A wider narrative is needed to fully frame risk for longer term investors

I read Dan Bortolotti’s “3 Reasons to ignore market downturns” last week and the more recent Jonathan Chevreau’s “If you can’t take the pain of plunging markets, don’t watch”.

They both pass some genuinely rationale advice…if you have a long term portfolio structured cognizant of risk then there is no point in reacting to a boundary you have already accepted you will cross numerous times.   But just what are the boundaries that you have accepted and just what are the risks since it is the context in which the statement is made that matters?

In his first point Dan pointed out that a “reasonable expected rate of return” for a global equity portfolio might be between 7% and 8%.   He reasonably pointed out that returns are never a steady average but a series of highs and lows of varying magnitude.  Nevertheless the 7% to 8% expected rate of return is I believe a touch optimistic and not entirely reflective of the current contextual narrative.

We have been trending for some time to much lower nominal economic growth rates and the prices of assets, in response to lower interest rates, have been likewise bid up reducing their return generating potential.  Returns have been heading lower on asset classes for some time, as has the economic growth supporting those assets.   We have been moving to a lower return environment and not naturally so.  In response to lower returns, interest rates have been lowered and as interest rates have been lowered, so asset prices and debt have risen.   What we have is a scenario where prospective returns are lower than historical returns and risks to those returns disproportionately higher.

The following chart shows the annual capital returns on the S&P/TSX (reconstituted back to 1970) over 10 year rolling time periods.  In other words the capital return you would have got at any one point in time by buying and then holding for 10 years (excluding any costs):

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What we can see is that the average 10 year capital return has been falling steadily over the period.   But what if we exclude inflation?

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On the surface real returns have been much more stable and over the last few years average 10 yearly returns have not been so far away from the historical post 1970 average.  That said, Canada is I believe at the peak of a golden age of investment returns, a peak that it reached at the cusp of the 2007/2009 financial crisis.  Prior to the current downturn in markets Canadian asset prices (house and equity and bonds) were pretty much in historically high valuation territory.  To suggest that investors remained in an historical risk/return frame for equity returns (as well as other asset classes) prior to this downturn is probably incorrect.

Indeed, if we look at longer average annual returns over 15 year time frames we find there have been fairly significant periods of poor market returns…what capital return would you have had if you had bought and held for 15 years between 1970 and 2000? 

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Actual historical returns have been very much buoyed by returns post late 1990s till the cusp of the 2007/2009 financial crisis.   If we were to exclude this period of debt financed asset purchases, falling interest rates, asset bubbles and strong commodity markets, long term returns to Canadian investment would likely have been lower.   I believe the frame we reside in is currently a deflationary one bordered by excess debt and negative demographic dynamics. 

We are on the wrong side of the upside on which historical returns are being calculated!

In fact, we can look at returns in a totally different, though hugely relevant, framework.  A lot of the ups and downs in returns of late, especially the ups, have been due to heavy falls in asset prices in various bear markets since the late 1990s.   If we exclude the lows and just focus on increases in capital value from the peaks, that is the real capital returns that have markets achieved from peak to peak, we get a more sobering analysis:

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Rolling 10 year capital returns for someone who remained fully invested in the market index have been negative more or less since the spring of 2010 and were negative more or less from the early 1980s to the mid to late 1990s.  In other words, excluding dividends, it has only been the ability to buy the dips amidst the asset price bubbles of the late 1990s onwards that has allowed investors to generate real long term capital returns from equity markets. 

Dividends have been all important and for those who are reliant on their assets to meet their expenditure needs this means that capital, that will more often than not be withdrawn to meet expenditure, has been exposed to much greater risk.   The above analysis excludes dividends to allow more effective analysis of fundamental asset class return and risks.  It is important to note that the capital return indexes represent expected total economic return and therefore reflect all expected consumption and all expected investment/saving.

Assuming the deflationary frame, high asset prices and high levels of debt supporting those asset prices potentially expose investors to significant long term capital investment risk from here on.  The longer term historical return narrative used by many to placate investors may well be one of the biggest risks to investors going forward.

This does not mean that investors should be selling all their equities, but it does mean lower return expectations and higher expected risks.   Which means that withdrawal expectations may need to be “trimmed back”.  If the time frame of risk associated with risky investments is extended, then this also likely means that the portfolio itself will need to reflect this higher risk to withdrawals by better structuring the lower risk liquidity profile of the portfolio – effectively more to lower risk asset classes.  Which is a bother because yields on lower risk assets are low which means securing capital certainty in exchange for perhaps higher yield and questionable growth potential.  

It is unfortunate that we are also in a quantitative easing epoch when central banks by buying up lower risk assets in exchange for cash push both cash and lower risk asset class investors into higher yielding peripheral asset classes.   All in all, we have higher risk and certainly higher risk to returns which should all things being equal lower return expectations.  It is likewise unfortunate that our financial and economic framework is dependent on investors remaining committed to their long term exposures to risky asset classes.   A wholesale realignment of allocations would spell the end not only of markets but also economies.  

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