How big of a return should you expect from your investments? (It may be less than you think)
Trying to predict stock returns with any degree of certainty is not recommended. But when it comes to planning for long-term financial goals like retirement or post-secondary education, experts say certain assumptions need to be made.
“When we’re talking about expected returns, we’re just talking about a reasonable number that we can use for the purpose of projecting into the future,” Benjamin Felix, an Ottawa-based portfolio manager and head of research at PWL Capital, told Yahoo Finance Canada. “It doesn’t necessarily mean that you’re actually going to get that outcome.”
It’s good to be conservative, because overestimating future returns means you might not meet your financial objectives, says Nick Hearne, financial advisor and associate portfolio manager at RGF Integrated Wealth Management in Vancouver. On the other hand, setting your expectations too low may lead to unnecessary saving, he adds.
“If we’re too conservative, perhaps we don’t live the life that we want to live,” Hearne said in an interview with Yahoo Finance Canada.
So, what is a reasonable rate of return for Canadians to plan around?
Don’t expect double-digit returns
Felix finds there’s a common belief, often based on the exceptional recent performance of the U.S. market, that stocks will yield an average annual return of 10 per cent or more. Over the past 20 years, ending in December 2023, the S&P 500 delivered an annualized return of 9.69 per cent. But Felix says using these figures to project future returns is problematic.
For one, it ignores historical periods when the U.S. market struggled. And it doesn't account for the rising valuations of U.S. stocks relative to their earnings, which he says have driven up past returns, and, consequently, driven down expected future returns.
“If people look at the U.S. market and say, ‘That same thing is going to happen for the next 10 or 20 years,’ I don’t think that’s a reasonable expectation,” Felix said.
“You should actually have the opposite expectation.”
Felix’s firm, PWL Capital, projects average annual returns of 6.83 per cent for U.S. stocks, 7.32 per cent for Canadian stocks, and 7.86 per cent for international stocks over the next 30 years, as per its 2024 financial planning assumptions. The projected annual return for the global stock market, which Felix generally recommends for diversification, is 7.24 per cent.
Similarly, FP Canada, the professional body for certified financial planners in Canada, projects long-term annual stock returns of between 6.4 and 8.3 per cent (Felix and Hearne both sit on the committee that oversees the projections, which are based on assumptions provided in the Quebec Pension Plan and Canada Pension Plan actuarial reports, a survey of industry leaders, the current earnings yield, and historical market performance.)
However, Felix and Hearne stress that these are all nominal returns, which don’t account for expenses and inflation. Planning around nominal returns isn’t the right approach, because inflation reduces the real value of your returns, affecting how much you can actually spend in the future.
“Whenever we’re doing planning, what we really care about is purchasing power,” Hearne said. “So, we look at the nominal return, which is the total rate of return earned by an investment, and then take off the inflation rate to get the real return.”
Any administrative and investment management fees also need to be subtracted in order to obtain a true net return, the FP Canada guidelines state.
Real stock market return estimations are closer to 5%
Accounting for an expected inflation rate of 2.5 per cent, PWL’s long-term projection for global equities drops from 7.24 per cent to a real annual return of 4.62 per cent – or 4.47 per cent after fees. Taxes may cut into returns even further, Felix notes, depending on the type of asset and the account it’s being invested in.
Ultimately, the actual return of a portfolio is going to be driven by several factors, including an investor’s risk tolerance, Hearne says. All the projections above assume portfolios composed entirely of stocks, which come with significant volatility.
In contrast, FP Canada projects that a more balanced portfolio – holding 50 per cent stocks, 45 per cent fixed income, and five per cent short-term investments – would yield a nominal annual return of around five per cent, or 2.75 per cent real, before fees.
The probability of achieving any projected return is “pretty low,” Felix notes. With capital markets, there’s always going to be a range of potential outcomes. But he says having unrealistic expectations can be “extremely damaging” to someone’s future plans.
“It’s like using the wrong map to try and get to where you’re trying to go,” he said.
Farhan Devji is a freelance journalist and published author based in Vancouver. You can follow him on Twitter @farhandevji.