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By John De Goey, CFP, CIM
Special to Financial Independence Hub
When I ask clients and prospective clients about the return expectations they have for their portfolios, the responses vary wildly … anywhere from ‘about 5%’ to ‘over 10%.’ Almost all of these expectations are too high.
Admittedly, clients have different risk profiles leading to different asset allocations and ultimately, different outcomes. That’s reasonable. A problem crops up when otherwise reasonable people have been socialized into having out-sized expectations. How does one ethically re-calibrate expectations for irrational optimists who nonetheless think they’re within their rights to have those expectations?
The behavioural finance concept is overconfidence, although the attitude involves elements of optimism bias, cognitive dissonance and old-fashioned hubris, too. To quote J.M. Keynes: “Markets can remain irrational longer than you can remain solvent.” Few investors are prepared to acknowledge that the recent bull market seems unlikely to continue and that a recession appears to be on the horizon.
Learning from past Crashes
If we have learned anything from the great crashes of 1929, 1974, 2001 and more recently, the global financial crisis, it is that investors (often spurred by accommodative policy positions) can come to think of themselves as being all but invincible when central bankers are accommodative. Too often, they also lose their nerve when markets tumble and stay low for a prolonged period.
A good deal of personal finance is grounded in social psychology: especially group psychology. People can get ahead through investing not only by being shrewd about valuations and such, but also by accurately anticipating how other market participants might react to a given set of circumstances. Of course, it cuts both ways: and having reasonable expectations in the first place often assists investors in staying the course.
My concern is with the messaging being offered by many in the personal finance community these days is something I call “Bullshift.” The industry shifts peoples’ attention to make them feel more bullish. To hear many in the business tell it, there’s no appreciable need to be concerned about high valuations, high debt levels (both public and private), a long-inverted yield curve and interest rates at generational highs. Any one of these considerations would ordinarily give a rational investor pause. Taken together, they pose a clear and present danger for investors in the second half of 2024. Few seem concerned and it is that very lack of concern that concerns me.
Misleading investors with “Bullshift”
There is a directionally and mathematically accurate ad running by Questrade making the rounds that doesn’t tell the whole picture, either. Again, even the ‘good guys’ tend to mislead the average investor with Bullshift. The advertisement shows what you would earn over a long timeframe at 8% and what you would earn at 6%.
My question to you is simple: is it reasonable to assume an 8% return is even possible? There is longstanding evidence that higher-cost active investment strategies actually fail to outperform cheaper strategies such as passive index investing and that product cost certainly does matter.
However, FP Canada, the people who confer the CFP designation, tell practitioners that they should be assuming a return of under 7% for an all-equity portfolio invested in developed markets. That’s the expectation before product fees (typically 0.25% to 1.25%) and advisory fees (typically about 1%). In other words, even an all-equity portfolio should be expected to grow at less than 6%. If costs are higher and there’s more than just a little bit of fixed-income exposure, the expected return ought to be under 5%.
Getting what you DON’T pay for
In a paper called ‘The Arithmetic of Active Management,’ written more than 30 years ago, Nobel laureate William F. Sharpe showed that before costs, expected returns for active and passive approaches are identical. As such, the average low-cost passively invested dollar must – by definition – outperform the average higher-cost actively managed dollar. If the passive investor’s return is the benchmark, then the average active investor must earn the benchmark, too: before accounting for fees. In the end, the difference in cost is all that’s left to differentiate the two approaches. To quote the immortal John Bogle, in the end, investors “get what they DON’T pay for.”
Lowering your cost is like getting an expected dollar-for-dollar return enhancement with no change in risk. That’s critical because returns are likely to be much lower going forward than what people have grown accustomed to, and few in the financial advice industry seem prepared to disabuse investors of their overly optimistic outlooks.
Using FP Canada Guideline assumptions, a standard 60/40 split portfolio’s base return might be about 5.6 per cent before product costs and advisory fees. This expectation might be lowered to about 4.3 per cent with an advisor who uses passive ETFs as building blocks, and only about 3.5 per cent for an advisor who uses commission-free or ‘F-Class’ mutual funds.
The days of high returns are coming to a close. Don’t shoot the messenger. Investors often claim they want an advisor who will ‘tell it like it is’ but almost no one wants to be the bearer of bad news.
John De Goey, CIM, CFP, FP Canada™ Fellow, is a Portfolio Manager with Toronto-based Designed Wealth Management. He is the author of three books on the financial industry: The Professional Financial Advisor, Standup to the Financial Services Industry and most recently, Bullshift.
The information contained herein has been provided for information purposes only. The information has been drawn from sources believed to be reliable. Graphs, charts and other numbers are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. This does not constitute a recommendation or solicitation to buy or sell securities of any kind. Market conditions may change which may impact the information contained in this document. Designed Securities Ltd. (DSL) does not guarantee the accuracy or completeness of the information contained herein, nor does DSL assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Before acting on any of the above, please contact me for individual financial advice based on your personal circumstances. DSL is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada.
