A recent article in The Wall Street Journal on historical portfolio returns and risks prompted this week's column. I'm a trust-but-verify person; so while I could not confirm the numbers that appeared in the Journal, I was able to create a similar example here.
Average volatility in the U.S. stock market as measured by the CBOE volatility index (VIX) has never been lower. Sentiment surveys of professional investors like Investors Intelligence has close to the highest percentage of bulls since the 2015 market highs.
Average daily trading ranges have narrowed to the lowest level in years in the past few months as complacency has set in and valuations are very high. Is this the calm before the next storm? Why do I suggest the risks of returns are so high?
We all know or have heard that past performance is no guarantee of future returns – in fact this statement is basically in the fine print of every document you will ever read in the financial services business. It is the essence of what investors should understand about markets but few actually do. And it's not until markets decline considerably (20 per cent or more) that most feel the pain or start to ask questions. This is why the markets are at their riskiest point in history: You have to take a lot more risk in your portfolio today to get that average return than any point in the past 25 years. The primary reason is that bond yields are so low.
Most investors would be pleased with inflation running below 2 per cent to get a real return of 5 per cent on their invested capital. That would provide a nominal return of 7 per cent. Turning the clock back 20 years (and who wouldn't want that opportunity?) one could have invested 100 per cent of their savings in a diversified corporate bond fund (bond ETFs did not exist until 2000) to get that 7-per-cent return with about a 6-per-cent standard deviation in your portfolio.
Standard deviation is a measure of volatility of returns in your portfolio. It's a statistical measure that looks at the average return over time and how much the periodic return has been different than the average. Here are my calculations: An average return of 7 per cent over 20 years with a standard deviation of 6 per cent means that the range of returns were between plus 19 per cent in the best year and minus 5 per cent in the worst year in 19 of the 20 years.
Unfortunately, when looking at past returns, there is rarely a reference to the risk you needed to take to get that past return. Ten years ago, to get that average 7 per cent return in your portfolio, you could not have done it with the same risk.
The cost of that 7 per cent return was a standard deviation of closer to 9.5 per cent to get that average return. The range of returns over the past 10 years, all will know, was more volatile: plus 25 per cent to minus 12 per cent for this balanced portfolio. The portfolio consisted of about 50 per cent in corporate bonds and the balance in equity markets that are historically more volatile in their average returns compared with bonds.
Currently, a passive buy and hold portfolio that is expected to have a 7 per cent average return for the next 10 years comes mostly from international equity (non-North America) investing, which historically has significantly more volatility (risk). I used the 10-year forward returns suggested by Research Affiliates. They are one of the top U.S. firms that forecast expected returns and they provide free monthly updates on their website researchaffiliates.com.
These returns are from the perspective of a U.S. dollar investor without hedging currency exposure. The holdings can mostly be replicated by way of Canadian ETFs so it would be possible to build a low cost (in terms of management expense ratio, or MER) buy-and-hold portfolio with ETFs. But the real cost is the expected volatility of 19.2 per cent. The range of returns over the next decade is likely to be between plus 45.4 per cent and minus 31.4 per cent. You must understand that loading up your portfolio with more equities when the valuation is extreme is eventually going to lead to a massive drawdown. The question you need to ask yourself is: Can you handle the ride? Most say they can, but in fact panic at some point after seeing the paper losses and liquidate when they should be buying.
This biggest cost of investing in your emotional response. Ask your adviser what the expected return and volatility is in your portfolio so you will know whether you can handle the ride.
A sample ETF portfolio
Here is a sample buy-and-hold portfolio that could achieve an estimated 7-per-cent return over the next decade with a standard deviation of 19.2 per cent.
- 40% BMO MSCI Emerging Markets Index ETF (ZEM)
- 30% Vanguard FTSE Developed All Cap Ex U.S. Index ETF (CAD-hedged) (VEF)
- 10% iShares U.S. High Yield Bond Index ETF (CAD-Hedged) (XHY)
- 10% First Asset Canadian REIT Income Fund (RIT)
- 5% iShares U.S. Small Cap Index ETF (XSU)
- 5% iShares S&P 500 Index ETF (XSP)
Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor.