Hi Q. Good to see you again. Have you seen the new Avengers movie? I took my kids to it. Talk about beating the benchmark… WOW!
Q: Hi Mark! I could use some of those superpowers for my investments. At our last meeting, you said that you did not think that the portfolio management fees I pay each month were worth the performance my manager delivers. The evidence you provided was compelling. After a little digging, I realized my performance did not justify the fees – not even close. I could have done better by randomly investing in a bunch of stocks. What should I do?
A: Sounds like you may be in a stuck in a parallel universe or something! Listen, I am no Tony Stark, but I think you should start by asking yourself – what is reasonable to expect from the markets over the next 10-15 years?
Q: Well, you have said that investors should probably not expect the kind of returns that we have had over the past 30 years i.e. about 9% for both bonds and equities.
A: Stocks and bonds have both benefited from a 37-year period of generally declining or stable interest rates. As rates fell, since peaking in 1981, bond prices climbed, and returns were strong. Here lies the problem. The last 37 years is not repeatable. You cannot have interest rates continue to fall indefinitely. In fact, rates have already risen modestly from record lows. If this continues, we should not expect returns on bonds to be much more than 3% over the next 10-15 years.
As for stocks, we are now in the 10th year of the longest bull market for U.S. equities in history. Valuations in the US are much higher than in other countries. Markets in Canada, Europe, and Asia have also done well but have generally lagged the US. Is this likely to continue? Probably not. We should expect some reversion to the mean over time, with the US underperforming the rest of the world. Economic growth is also slowing. I think that roughly 5-6% return from stocks in the developed markets and perhaps 8-9% in emerging markets are realistic.
So, for a balanced portfolio of developed market equities and bonds, I would expect a return of averaging about 5% going over the next 10-15 years. It could be higher or lower than 5% but given where we are now, this seems a reasonable assumption.
Q: Well, even 5% doesn’t sound so bad. I could live with that.
A: How are your math skills?
Q: I am no Dr. Bruce Banner… but I get by. What’s your point?
A: Well, 5% is a decent rate of return in a low inflation period like the current environment. However, let’s look deeper. Let’s say you r income tax rate is 20% in retirement and inflation averages 2% per year. Since your manager’s fee is high at 2% per year, you are earning a real rate of return of only 0.40%. (#_ftn1) You would barely be keeping up with inflation.
Q: So, I might as well just put it all in GICs, get my 2.0-2.5% return, and be done! My return is guaranteed – and no daily volatility. What is wrong with that?
A: You could do that, but you may be taking too little risk. You will still not be much farther ahead in real terms when you retire. People need to start thinking in longer-term buckets. After all, as 50-year old, you could very well live another 40 years or so. Ask yourself, if your strategy is not working now, when is it going to work?
Q: Okay, I agree. I need to think long-term. GICs won’t cut it. But neither will what I am doing now!
A: Over time, the stock markets should deliver about 3% real return for developed markets and somewhat more in developing markets. This is still very good. Also, there is still opportunity in bonds, especially in higher yielding corporate bonds. Plus, bonds are an excellent diversifier.
Q: Agreed. But It’s not working for me. My manager keeps telling me that it just takes patience – performance will get better.
A: For most investors, hiring active managers that pick stocks is not the answer. Sure, they may beat the benchmark in a given year. But are they going to add value over your 40-year time horizon? Extremely unlikely. The odds of picking that elusive great stock picker in advance are just as remote.
Focus on what you can control. You can’t control the markets, inflation or interest rates; but you can control how your money is managed and the fees that you pay. That 2% annual fee is egregious. Investment managers often get paid better than surgeons. If only 10% (#_ftn2) of surgeons were successful, I wouldn’t leave my house.
Pension plans don’t pay 2% in fees, and neither should you.
Q: I get it. I can’t control the markets or inflation, but I can control how I deal with it. That’s the Endgame!
A: Exactly. Focus on what you can control: Contribute regularly, don’t time the market and don’t try to pick individual stocks (unless you are prepared to lose) and work with a trusted advisor; one who works in your best interests, not just for those of the company’s shareholders or their own pockets; one who properly diversifies, takes appropriate risks and charges a reasonable fee. If you do that, your investment program will be a success. It’s as simple as that. Endgame indeed!
“It is not necessary to do extraordinary things to get extraordinary results”.
– Warren Buffett
 (#_ftnref1) [(Return – Fee) x (1-Tax) + 1] / (1+Inflation) – 1 = [(.05-.02) x (1-.20) + 1] / (1+.02) -1 = .0039 ≈ 0.40%
 (#_ftnref2) Only 10% of Canadian equity managers outperformed the S&P/TSX Composite Index over last 5 years.
Mark Doyle, CFA
Marksman Asset Management Inc.