Low bond yields make for tough decisions

I have been involved in several client proposals and meetings over the past several weeks.  A common thread continues to emerge in most cases.  Since bonds are needed to limit total portfolio risk, they also limit potential total returns.  And this is causing investors to have to choose whether risk or return is more important.

Total Returns

Near the middle of this year, I laid out the thought process behind why I expect a balanced portfolio to generate a long term return of 6.5% annually.  Stock and bond prices have since risen.  By definition, today’s higher market prices equate to lower returns in the future.  My partners and I are no doom-and-gloomers but we are being honest with our long-term expectations – and doing what we can to tilt the odds in our clients’ favour whenever possible.

And we’re still reasonably positive on the prospects for future stock returns.  While not dirt cheap, stocks are generally priced for long-term returns of about 7% to 8% per year by my estimate.  But a Canadian bond market yielding just 2.3% puts balanced portfolios into a modest range of potential total returns – even before fees.

(As an aside, it will also put more pressure on already-hurting load mutual fund companies, whose relatively higher fees are likely to make already-modest returns even skinnier.)

Great Expectations

There was a time when investors would routinely expect return levels that were just unrealistic and not highly probable at any risk level.  I remember hearing expectations of 8% to 12% or more per year quite regularly for balanced portfolios.  The conversations would then end with guiding clients to look at something in the 6% to 8% range.

To their credit, many clients today expect or need much more modest mid-single-digit returns.  While this performance level is quite achievable, it’s no slam dunk – particular for conservative or balanced investors.

Decisions, Decisions

In most cases, however, investors are expecting performance that does not line up with the level of risk exposure they’re prepared to assume.  This leaves investors with some difficult choices.

Some investors are willing to accept lower returns in order to stick to a stated level of risk.  These investors’ portfolios are designed to meet certain risk constraints and are prepared to let the return chips fall where they may.  This will require either accepting a lower standard of retirement living or simply delaying retirement by a few years.

Others aren’t prepared to sacrifice their return targets, which means they’ll need to get comfortable with exposing their portfolios to higher levels of risk.  And yet taking more risk is no guarantee of higher returns, though it generally increases the chances of achieving higher returns.

For well-heeled investors, it’s not a terribly difficult situation if they have more money than they need – often the case for this group.  For the remaining majority, however, these are the tradeoffs that today’s market reality impose on investors and their advisors.