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Curb your expectations – Expected investment returns redux.

Canadian investors had gotten used to double-digit returns. From 2003 to 2007, a balanced portfolio with a blend of stocks, bonds and real estate (I.e. real estate investment trusts or REITs) delivered returns well above historical averages. It was a good run.

Then, when 2008 ended badly and 2009 started off worse, investors became more concerned with return OF capital rather than return ON capital. And lower historical averages didn’t look so bad after all.

Could it be true what the mutual fund literature sayeth; ‘Past performance is no indication of future results’? What can investors expect going forward?

Historical returns are the usual starting point (like a blunt instrument) for planning purposes.

Here’s the problem. Declining interest rates were a powerful driver for stock, bond and real estate prices for nearly three decades. Since short-term interest rates peaked at just over 20% during August 1981, they’ve dropped to 60-year lows of near zero today and aren’t likely to drop much further. (They may not go up either but they can only drop to zero).

In the absence of further interest rate declines, investors can normally depend on growth for returns. But Export Development Canada says the world economy will in fact contract by -1.75% this year. A normal recession sees world growth slow to 1% to 2.5%. -1.75% doesn’t even make the charts. EDC also says don’t expect improvement until late 2010 at the earliest. Without growth, the economy could drift sideways for months (or years). Sideways drift means little capital gain (or loss) in the stock, bond and Reit markets that reflect the economy. (It doesn’t mean there won’t be volatility).

It might be more realistic to plan on just the income from investments alone.
J.P. Morgan says normal stock returns are a combination of earnings growth plus inflation plus dividend yield. Corporate earnings can only grow as fast as the economy and no economic growth and no inflation would mean investors will have to settle for just dividend yield alone. Today, Canadian dividends yield are about 4% to 5%.

John Bogle, founder of the Vanguard index funds, says that future returns from government and high quality corporate bonds are always very close to today’s bond yield. Today, Canadian short-term bonds yield about 4%.

Reit returns, too, come from income yield plus rental growth. According to the National Association of reit’s, the income component is normally about 5% to 6%. Today, Canadian Reits yield at least that. (No. Don’t put all your money in Reits! Stay diversified).

For a portfolio balanced with stocks, bonds and Reits, the expected return math is unfortunately simple. Given no or low economic growth for the next year at least, investing for income is likely to be more successful than investing for growth.

Originally published August, 2009.

Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.


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