Rates of Return - What Should You Expect

One of the most common questions I get is, "what is my rate of return going to be?"

The most honest answer I can give is, "I have absolutely no idea," but that doesn't really instil a lot of confidence, does it?

Back when I first started, it was easy to look back at the history of a fund or a portfolio and say something like, "Well, this fund got 7.3% over the last 20-years, so hopefully it's somewhere in that range."

The problem with saying this is that people hear what they want to hear. I always use assumptions, but if I'm not perfectly clear, that can be mistaken as me saying that's what a client can expect to get no matter what. 
I often hear people say, "My guy said I'll get 7.3%." I hope you're not working with a guy who said something like that, because you have to understand that we don't know what return you'll get and it's all based on assumptions that we make. I could assume you'll get a 20% rate of return right now and tell you that, but it sure as hell doesn't mean I will be right. Another thing to realize is that if we are using a projection of - for example 5.0% - that does not mean you can expect a rate of return of 5.0% every year, it means that we expect the average over a long period of time (at least 10-years) to be about 5.0%.

Hopefully it's much higher, but it could very well be lower. Believe me when I say that there's not one financial planner or advisor who wouldn't want their clients to get a huge long-term rate of return. We know we are judged on how your investments do, plus we make more money if you have more money, so it's not like we are ever trying to give you advice that will result in below-average returns.

However, using past returns is a bit of a dangerous game, because past performance has nothing to do with what is going to happen in the future. If past performance was indicative of what would happen in the future, then investing would be very easy and everyone would be very rich.

Past performance has nothing to do with what is going to happen in the future

Truth be told, investing is pretty easy, it's just hard to control emotions and not make bad decisions. There's also a lot of bad information out there, so it's hard to know who or what to trust.

Today I just want to talk about what we are SUPPOSED to tell clients to expect when we are projecting rates of return.

FPSC Projection Guidelines

There is an entity called the Financial Planning Standards Council, which basically regulates Certified Financial Planning Professionals in Canada. I pay them when I renew my Designation every year, they come up with the requirements we have to meet to become CFP Professionals and they make sure we are keeping up with the professional standards required to maintain our designation.

Now, every year they send us a big document which talks about projected rates of return moving forward. How they come up with all of these numbers and all of the data they use is not really what you need to concern yourself with, but If you want to read the whole thing, here is the link: http://www.fpsc.ca/news/publications-research/projection-assumption-guidelines

These projections are very important though, because financial planning has a lot to do with making certain assumptions and one assumption we always have to make is what your rate of return is going to be.

Let's say you have a guy who is doing a plan for you and he decides to make himself look better than the next guy by telling you that you can expect an 8.0% rate of return when he was supposed to use 4.0%. You might now be under the impression that you're well on your way to a comfortable retirement and then when you think you're set to retire you realize that you only have a fraction of what he said you would.

Just look at the difference of saving $500/month from age 30 to 65 at 4.0% and 8.0%:

4.0%: $456,865

8.0%: $1,146,941

The moral of this story is to just realize that you are going to want to make sure that you're being told realistic expectations so that you know how much you should be saving in order to achieve your goals. I wish it was mandatory for us all to use the same assumptions, but unfortunately it isn't.

Let's Look at Moderate Portfolios

If you've ever watched my videos about investing, I try to encourage people, especially younger people, to take a little more risk with their investments in order to hopefully achieve higher returns over the long-term. However, if you're not comfortable with larger market fluctuations and you'll end up just selling at a low point, the risk will not be worth the potential reward and it will backfire.

First I just want to explain a few things about their projections for a Balanced Portfolio and how I have come up with my numbers.

Balanced Portfolios are super popular, because they allow for decent growth, but are also protected fairly well against market downturns. Balanced Portfolios are typically made up of approximately 60% Equities (Stocks) and 40% Fixed Income (Bonds).

Then there is a mix with the Equities that can fluctuate, but it's somewhere around:
20% Canadian Equities
30% US/Foreign Equities
10% Emerging Market Equities

These are the numbers I have decided to use for what a Balanced Portfolio is made up of and that is how I made the overall projection. It's pretty close to what a typical Balanced Portfolio is made of, give or take a few percentage points in each geographic sector.

So, when we look at the FPSC Guidelines, this is what they suggest we are supposed to use as projections for each sector mentioned above:

Fixed Income:                            3.9%
Canadian Equities:                   6.4%
US/Foreign Equities:               6.7%
Emerging Market Equities:    7.4%

So, if you make the portfolio I mentioned above (40% Fixed Income, 20% CDN Equity, 20% US/Int. Equity, 10% Emerging Markets), that would equate to a projected return of 5.59% for a Balanced Portfolio.

That's pretty sweet stuff, but it's not quite so simple. That is making the assumption that there are absolutely no fees associated with investing and the FPSC makes it abundantly clear that you need to subtract the investment fees to get your actual projection.

Look closely at the top and bottom line. Also, their Balanced Portfolio is different from what the Balanced Portfolios at the major institutions are made of, which is why my numbers are different.

Look closely at the top and bottom line. Also, their Balanced Portfolio is different from what the Balanced Portfolios at the major institutions are made of, which is why my numbers are different.

Now that we've sort of cleared all of that up, let's look at some different options, what fees you would be paying with each option and what projected rate of return you should be told to expect.

Now, I want to be very clear that the lowest fee option is to find a way to build your own portfolio, which would be almost fee-free. This will most likely result in the best long-term returns and your next best bet would be to use a Robo-advisor to build the portfolio for you and rebalance it when necessary.

However, I am also certain that working closely with a Financial Planner will help you to make good decisions and increase your net worth over time. Numerous studies have proven this to be true.

I also want to make 100% clear that just because this is what is projected, does not mean that this is what is going to happen. It does not mean that the portfolios will return these amounts and it does not mean that just because you are paying lower fees that you'll get a better return.

So with that said, let's look at the projections you should use/be told if you're invested at a whole bunch of different firms:

Rates of Return - Assumptions

Now, if you look at the bottom row, it shows K4 Financial and what we would show for a Balanced Portfolio when we are doing our reports. So this would mean we could show an assumed return of 4.44% and let's say that we are developing a plan for someone who has all of their money in an RBC Select Balanced Portfolio, then we can safely assume we should be able to project returns that are 0.79% higher, because the investments are extremely similar, but the fees are lower.

That's what everyone needs to really understand; every single portfolio listed above is made up of the same parts. They aren't exactly the same, but they're all very close and the only real differentiator that matters is how much each one costs.

You'll notice that we charge 0.60% on top of what Wealthsimple charges, so we will make it very clear to our clients that they will have better returns if they aren't paying our fee. That means that we have to provide that level of value or more, otherwise it isn't worth it to pay for our services and advice.

Now I want you to go back and look at where your money is invested. Is your adviser using retirement projections that are a lot higher than what is shown for the returns you should be expecting/assuming? If so, you are potentially being misled down a path that will result in a retirement that is a lot less exciting than you were expecting.

Conservative and Moderate Aggressive Portfolios

Using simple math and portfolios, here's approximately what you should be using as a projection for Conservative and Moderate Aggressive Portfolios:

CONSERVATIVE (60% Fixed Income, 40% Equities): 5.00% minus investment fees

MOD. AGGRESSIVE (20% Fixed Income, 80% Equities): 6.14% minus investment fees

The bottom line is that you have options to reduce your investment fees and every single study that has ever been done will show that your chances of achieving higher investment returns are directly correlated to how much you're paying in fees. These savings may appear insignificant because they're invisible, but could mean hundreds of thousands of dollars in your pocket later in life.

Start asking questions and don't feel bad about it. This is your money and it's your future.