Stay invested and lower your expectations: don't let short-term volatility harm your long-term outlook

Money Digest, Sept, 2002 by Chris Cahill

The last two-and-one half years of volatile markets and disappointing news have made investing frustrating for clients and advisors alike. Compounding the problem of unstable markets is the notion that through the 1990s double-digit returns were normal. There is no one who would like to protect and grow capital and see accounts perform well more than a financial advisor. Reevaluating expectations is a great challenge for clients as well as advisors. Although this can be emotionally draining, it is essential to achieving the financial future that is desired by the client. The consensus among advisors is that future returns will not come close to those of the '90s.

If clients and advisors do not recalibrate, re-educate and resubmit financial plans with proper expectations, retirement goals will not be met. People must restrain themselves from making inappropriate financial decisions. Such behaviour is often motivated by short-term events and is detrimental to longterm returns. It is tempting to make hasty; "quick-fix" decisions. For example, turning to GICs and term deposits may seem initially appealing. However, after taxes and inflation will erode capital faster than temporary capital losses.

Time and energy must be directed at managing emotions. As author Nick Murray has so eloquently stated, "You do not protect your investment capital by taking it out of the equity market, but by leaving it in, where it will remain exposed to the healing power of time."

The healthy returns of the past decade were based on declining interest rates and inflation that fueled strong profit growth. Over the long term, stock market returns are tied to corporate profits. Corporate profit growth is expected to slow from the past decades of high inflation rates.

Long-term research (1802 to 1997) on U.S. equity markets done by Jeremy Siegel (Stocks for the Long Run) has provided some very interesting statistics. Over the research period, the purchasing power of equities dominated all other assets and the stability of that purchasing power has been remarkable! Stocks yielded between 6.6% and 7.2% after inflation in all three major sub periods analyzed. In contrast, a real return on fixed income assets declined significantly over time, 4.8%, 3.7% and 2.0% respectively for the sub periods from 1802-to-1870, 1871-to-1925 and 1926-to-1997. In fact, since 1926, fixed income has returned to a nominal amount after inflation of 3.5% while equities after inflation and excluding dividends has returned 7%.

Greg Alexander, Senior Economist at TD Bank, argues that studying past market performance can be misleading because economic conditions in the years ahead may support different returns than in the past. Using conservative economic and financial assumptions, Mr. Alexander forecasts that investors can reasonably expect average nominal annual returns of 8% from the Canadian markets, 9% from American markets and 10% from Global markets over the next 10 years.

Whether or not advisors and clients use historical returns, all research confirms that, going forward, single-digit returns are expected. One can also extrapolate that over the long-term, equity returns will exceed inflation by 4%-to-6% and will exceed fixed income by approximately 2%.

The point being, if investors and advisors do not recalibrate their expectations, they will not accumulate the money needed to support the retirement and lifestyle they dream about. The best way to deal with unpredictable markets is to stay invested and to maintain a realistic return expectation. Concerns established from short-term market volatility can be addressed with a detailed retirement plan and confirmation that one's investment strategy is meeting the desired goals. One's portfolio needs to be diversified by asset mix, investment style, geography and company size. A well-structured investment policy statement helps keep people on track. Sir John Templeton stated that most of his "opportunities always come when everyone else feels that the sky is falling". Now may be a good time to buy some sky!

Chris Cahill, B.A., C.F.P., C.L.U., Ch.F.C., is President of Financial Strategies Group, a broadcaster, a weekly columnist and co-author of Harvesting Your Wealth. Phone: (519) 438-3308; fax: (519) 438-7424.