10 Years Of Globally Diversified Balance

On this week's High Rock Weekly Video, Paul and I briefly discussed the long-term returns that we use to justify our expectations for long-term client portfolio growth assumptions.

We think that a portfolio of a blend of our 3 models should be able to achieve somewhere in the vicinity of 5-6% average annual growth over a multi-year period (before fees and taxes).

I thought I might go into this in a little more detail:

As we are reasonably close to the end of the 2007-2017 investment cycle (peak to peak), if we look at a global equity index (I normally like to use the MSCI All Country World Index, but there wasn't quite enough Bloomberg history, so I am using the MSCI World Index , fewer constituent companies, but generally the same idea) over the last cycle:

The 10 year average annual return has been approximately 7.45% in C$ terms (some years better than that average, some years significantly worse). That would represent a globally diversified equity portion of a portfolio.

In a 60% equity portfolio, this is a weighted annual average return of 4.47%.

As for the fixed income component, we can use the Canadian Bond Index ETF XBB:

The 10 year average annual return here has been 4.49%. This represents the fixed income portion. 

In a 40% fixed income portfolio this is a weighted annual average return of 1.80%.

Combining both of these gives us a total annual average return over the cycle of 5.87%.

Of course, historical returns are no guarantee of future returns, but can we let this be our guide for our expectations for future returns?

In the future, as we tell our clients, we will likely have some years that fall below the average annual return and others that might exceed the average.

As we take a longer-term perspective, we consider the most important part of our work to be not just getting decent (relative to historical averages) returns, but to get these returns in light of taking reasonable risk.

At the moment the risk free rate of return (a 90 day Government of Canada T-bill, no risk in owning this investment) is a little under 1%. That will not get you much after taxes (interest income is fully taxed at your marginal rate) and inflation (in the vicinity of 1.6%, but depending on where you live and what and how you consume).

So to stay ahead of inflation and taxes, you do need to take some amount of risk with your investments. The type of risk that you take can certainly influence the outcome. That is why we focus on the return per unit of risk. 

Even in a balanced and diversified portfolio, you can get risk that can unhinge a longer-term portfolio performance. Especially when the traditional correlations between equity and fixed income markets are no longer working to protect you.

The past 10 years (including the financial crisis) have hopefully provided you with something in the vicinity of the 5.87% with balanced and diversified investments alluded to above.

The next 10 years may not necessarily do the same because the risks change. Being on top of those changing risk parameters is extremely important. That is what we do to prudently protect our and our clients money: find good opportunities and understand the risks inherent in them.