Three steps to effective conversations about risk

Wednesday, February 29th, 2012

Among the most impor­tant things that good advi­sors bring is the abil­ity to help clients make the right trade-off between risk and return … and also to help clients under­stand the crit­i­cal impact of the time frame over which they hold invest­ments on the volatil­ity they experience.

One of the most impor­tant con­ver­sa­tions these days is about the amount of risk that clients should take in their portfolios.

This month’s col­umn in Invest­ment Exec­u­tive out­lines three steps to make that con­ver­sa­tion an effec­tive one.

Step One: Talk about long-term returns

You could start by remind­ing clients of after-inflation returns for dif­fer­ent invest­ments for the 84 years from 1926 (as far back as we have really good data) to the end of 2009.

This com­pares large cap US stocks to inter­me­di­ate, 5 year Gov­ern­ment bonds and T bills. Note that you should frame this in terms of real, after– infla­tion returns — what really mat­ters to clients invest­ing for retirement.

Note that after infla­tion, stocks have returned three times bonds and ten times T bills.

Then trans­late that return into the real return on client portfolios.

For some­one invest­ing $100,000 in stocks, the after-inflation appre­ci­a­tion of $259,000 is almost five times that in bonds and almost twenty times the gain in T Bills, which just barely beat inflation.

Step Two: The odds of los­ing money

Next, talk to clients about the his­tor­i­cal expe­ri­ence of los­ing money in stocks after infla­tion, based on dif­fer­ent hold­ing periods.

His­tor­i­cally, hold­ing stocks meant that after infla­tion you lost money about one in three years.

Look­ing at three year peri­ods reduces the chances of los­ing stocks to about one in four.

In ten year time­frames, investors lost money 12% of the time — based on the expe­ri­ence since 1926; you have to go out to twenty years to com­pletely elim­i­nate the chances of los­ing money in stocks.

Step Three: Com­mu­ni­cate this visually

Finally, por­tray the nature of the expe­ri­ence in a way that investors can relate to.

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Tags: Client Portfolios, Conversations, Critical Impact, Government Bonds, Holding Periods, Important Things, Inflation, Investing For Retirement, Investment Executive, Investments, Risk And Return, Stocks Bonds, T Bills, Three Steps, Three Times, Time Frame, Timeframes, Twenty Times, Twenty Years, Volatility
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Today’s Most Important Client Conversation

Wednesday, November 24th, 2010

Of all the assump­tions that go into retire­ment plans, none has a big­ger impact than the expected return on a client’s portfolio.

Media cov­er­age about the returns investors can expect is not gen­er­ally help­ful in bring­ing clar­ity to this ques­tion .  Often the media fea­tures attention-seeking apoc­a­lyp­tic voices of doom. And in part it’s because when the media talks about a return fore­cast, they often fail to clar­ify whether that return is before or after infla­tion and whether it’s for equi­ties only or for a bal­anced port­fo­lio.

Fram­ing a client conversation

Given the impor­tance of the deci­sion on the expected return on invest­ments, this is one of the most impor­tant con­ver­sa­tions you can have with your clients.

You could start by remind­ing clients that over the very long term, stocks have aver­aged a pre-inflation return of about 10% a year – even after the mar­ket tur­moil of 2008. Then acknowl­edge that in the last while, many cred­i­ble indus­try voices have sug­gested that it would be over-optimistic to expect this kind of return going forward

When it comes to your return assump­tions, there are obvi­ous costs to being too bull­ish — overly rosy assump­tions can result in com­pla­cency and ulti­mately dis­ap­point­ment as peo­ple to fail to save enough and fall short of their goals as a result.

But there’s a price to being too con­ser­v­a­tive as well, as overly pes­simistic assump­tions can lead to undue stress and to investors mak­ing bad finan­cial choices. After all, if you think you’re only going to get low sin­gle digit returns on stocks, why not just buy GICs?

Three key decisions

To think intel­li­gently about expected returns, you need to talk to your clients about three things.

First, shift their think­ing to after infla­tion or real returns  instead of the nom­i­nal, pre-inflation returns so com­monly used.  This way, you’ll focus on spend­ing power – what really counts in retire­ment. Indeed this is what sophis­ti­cated pen­sion plans and high net worth investors  focus on.

Sec­ond, you have to help clients extend their time­frame. The shorter their time­frame, the more dis­per­sion they’ll expe­ri­ence on returns – pick one year as your time hori­zon and you could expe­ri­ence swings of 50% in either direction.

Even five and ten year peri­ods sub­ject you to sub­stan­tial swings in returns on stocks, espe­cially if your clients do what many investors do – and set their expec­ta­tions based on what hap­pened in the last three to five years.

The only way to bring sta­bil­ity to investors’ expected returns is to fol­low pen­sion funds and high net worth investors – and look out fif­teen or twenty years. That may seem an unduly long time­frame to some clients, but in fact that’s the min­i­mum hori­zon that most Cana­di­ans need to think about. Even if your clients are a 65 year old cou­ple, half the time one of them will live to age 90. And one in ten cou­ples will see the last sur­vivor reach age 98 – a thirty-three time hori­zon.

Adver­tise­ment

Look­ing inside aver­age returns

The third key deci­sion for investors is to look beyond averages.

Recently, I sat down with Michael Nairne and his team at Tacita Cap­i­tal to look at data on stock mar­ket returns in the U. S. going back to 1926.

In the 85 years since then, after infla­tion returns have aver­aged 6.6%. The big dif­fi­culty with an aver­age num­ber is how often you’ll be below it. Given the hard­ships  imposed from under­per­form­ing a return assump­tion, when select­ing the fore­cast return for the equity com­po­nent of their port­fo­lio you need to help clients look beyond the aver­age return to the dis­tri­b­u­tion of returns that got to that aver­age –that will tell them how badly they might fall short based on his­tor­i­cal precedent.

Since 1926, there have been 65 twenty-year peri­ods. If we list the real returns dur­ing those 65 peri­ods from high­est to low­est – and look at how often  those returns hap­pened, here’s what you end up with.

Annual return after infla­tion in 65 20-year peri­ods -  1926 to 2009:

Pick­ing the right number

In rec­om­mend­ing  the expected return for the stock com­po­nent of clients’ invest­ments, you could pick the after infla­tion return that’s half way down the list – that would give you a return of 8.5%.  Despite this, given the price of falling short of the return assump­tion, few advi­sors would sug­gest assum­ing the his­tor­i­cal median of an 8.5% real return on stocks.

For most investors, assum­ing a real return on equi­ties of 3% to 5% will likely make sense; 5% was achieved two thirds of the time, 3% was exceeded 80% of the time.

To put these num­bers in per­spec­tive, the CPP Invest­ment Board assumes a real return of 4.2% for a port­fo­lio with a 60% stock weight­ing, reflect­ing equity returns of 5% or more. And a recent arti­cle in the Finan­cial Analyst’s Jour­nal fore­cast a real return of 4% for U.S. stocks.

Finally, for clients who want to be really cau­tious, you could pick 2%; 1.8% was deliv­ered 95% of the time, in 62 out of 65 twenty year periods.

Of note, the worst after infla­tion returns all occurred dur­ing the high infla­tion years in the 1970s. As a result, your rec­om­men­da­tion on the return assump­tion for the stock com­po­nent of clients’ sav­ings will be heav­ily influ­enced by your con­cern about a return to inflation.

Pick­ing the return assump­tion to rec­om­mend for equi­ties will vary with your own and your clients’ atti­tude towards risk – there clearly is no one right number.

How­ever, by focus­ing on after infla­tion returns, tak­ing a long term view and dig­ging deep into the range of his­tor­i­cal expe­ri­ence, you can help clients end up with a real­is­tic num­ber that strikes the right bal­ance between undue opti­mism and extreme pessimism.

To read the full col­umn in Invest­ment Exec­u­tive, click here:

http://​www​.invest​mentex​ec​u​tive​.com/​c​l​i​e​n​t​/​e​n​/​N​e​w​s​/​D​e​t​a​i​l​N​e​w​s​.​a​s​p​?​I​d​P​u​b​=​1​9​4​&​a​m​p​;​I​d​=​5​3​0​1​6​&​a​m​p​;​c​a​t​=​3​0​&​a​m​p​;​I​d​S​e​c​t​i​o​n​=​3​0​&​a​m​p​;​P​a​g​e​M​e​m​=​&​a​m​p​;​n​b​N​ews

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Tags: Balanced Portfolio, Clarity, Compendium, Complacency, Conversations, Disappointment, Doom, Financial Choices, Industry Voices, Inflation, Market Turmoil, Media Coverage, Media Features, Pessimistic Assumptions, Retirement Plans, Return Assumptions, Return On Investments, Target, Term Stocks, Undue Stress
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Hard Facts on House Prices

Tuesday, October 19th, 2010

Not many top­ics are more emo­tion­ally charged than house prices. Part of the rea­son is the amount of myth, anec­do­tal con­ver­sa­tion and pure mis­in­for­ma­tion on this topic.

In many cases, that cre­ates a big oppor­tu­nity for advi­sors to add value by intro­duc­ing facts and objec­tive information.

That’s been the sub­ject of my last two Globe columns — last week’s looked back at the his­tor­i­cal returns on home own­er­ship, today’s  exam­ines what cur­rent house val­u­a­tions look like by his­tor­i­cal standards.

Links to both columns can be found at the bot­tom of today’s email, should you want to email them to clients.

Houses as an invest­ment — the ver­dict of history

The last ten years have seen annual increases of 8% in house prices — the best decade on record.

Some Cana­di­ans expect those kinds of gains to con­tinue — and are almost sure to be disappointed.

So last week’s Globe col­umn tack­led the ques­tion:  What are the facts on his­tor­i­cal returns on houses?

Depend­ing on your source, the answer is that after infla­tion, returns on houses have been either slim or nonexistent.

Phil Soper of Royal Lep­age said that since the early 1960s, Cana­dian house prices have seen an aver­age annual gain after infla­tion of 2.4% — this com­pares to a long term real return on stocks of over 6%.

Another per­spec­tive came from Cyn­thia Holmes, who teaches real estate at the Schulich School of Man­age­ment at York. She sug­gested that over the longer term, on aver­age house prices only increase with infla­tion and there are no real returns at all — this is sup­ported by a study of houses in cen­tral Ams­ter­dam going back 350 years.

Con­firm­ing her view, in this weekend’s National Post Robert Shiller of Yale was quoted that from 1880 to 1990, US hous­ing prices yielded a zero rate of return.

Today’s email con­tains an inter­view with Cyn­thia on this — you can also watch it here:

http://​www​.cli​entin​sights​.ca/​v​i​d​e​o​/​c​y​n​t​h​i​a​-​h​o​l​m​e​s​-​a​-​l​o​n​g​-​t​e​r​m​-​v​i​e​w​-​o​n​-​r​e​a​l​-​e​s​t​a​t​e​-​r​e​t​u​r​n​s​/​t​y​p​e​:​i​n​v​e​s​tor

Hous­ing prices today — fairly val­ued or a bubble?

Today’s Globe col­umn shifts from the past to the present, exam­in­ing the sub­stance behind recent sug­ges­tions that hous­ing prices are at bub­ble levels.

In March, the New York Times devoted a rare arti­cle on Canada to this topic.

And a cou­ple of weeks back, David Rosen­berg of Gluskin Sheff released a report sug­gest­ing house prices could fall by 20%.

Here’s the Rosen­berg report:                                                https://​ems​.gluskin​sh​eff​.net/​A​r​t​i​c​l​e​s​/​C​o​f​f​e​e​_​w​i​t​h​_​D​a​v​e​_​0​4​2​3​1​0​.​pdf

Here’s how it was cov­ered in the Toronto Star: http://www.yourhome.ca/homes/realestate/article/799961–canadian-housing-market-correction-in-the-cards-says-economist

And here’s the New York Times story: http://​www​.nytimes​.com/​2​0​1​0​/​0​3​/​2​0​/​b​u​s​i​n​e​s​s​/​g​l​o​b​a​l​/​2​0​r​e​a​l​.​h​tml

Hous­ing prices through the lens of affordability

Phil Soper of Royal Lep­age points out that over time hous­ing prices and incomes move together — although there are lots of peri­ods along the way where incomes get ahead of prices or prices get ahead of incomes.

Since 1985, RBC eco­nom­ics has tracked afford­abil­ity of houses in 100 neigh­bour­hoods across Canada, look­ing at the per­cent­age of the median household’s income it would take to carry a 1200 square foot bun­ga­low, assum­ing a 25% down pay­ment and includ­ing util­i­ties and prop­erty taxes. The higher a per­cent­age of a household’s income it takes, the less afford­able houses are.

Today’s Globe col­umn con­tains a chart of his­tor­i­cal and cur­rent afford­abil­ity in Cal­gary, Mon­treal, Toronto and Van­cou­ver — this chart is found at the bot­tom of this article.

Since 1985, the aver­age pro­por­tion of income to carry a bun­ga­low across Canada has been 39% — Mon­treal ‘s been 37%, Cal­gary 40%, Toronto 49% and Van­cou­ver 57%.

There have been big vari­a­tions along the way of course — as house prices ran up in the 1980s, afford­abil­ity declined to the point that by 1990 it took an aver­age of 53% of income to carry a bun­ga­low, with Toronto hit­ting 73%. The high prices and the poor afford­abil­ity that resulted led to the lost decade for house val­ues in the 1990s, when prices actu­ally declined in real terms.

At the end of Decem­ber, afford­abil­ity in most mar­kets was close to his­tor­i­cal lev­els, although RBC points out this was partly a func­tion of mort­gage rates well below what would nor­mally be expected. When they did the cal­cu­la­tion assum­ing nor­mal mort­gage rates, afford­abil­ity dropped below the long term aver­age — the good news was that afford­abil­ity was still well above the all time highs.

The only mar­ket where alarm bells went off was Van­cou­ver — assum­ing nor­mal mort­gage rates, at the end of Decem­ber it would have taken 81% of a median household’s income to carry a bun­ga­low, just below the all time high set in early 2008.

Based on this analy­sis, today’s col­umn draws two conclusions.

First, with the excep­tion of Van­cou­ver, houses do appear expen­sive but are not at bub­ble levels.

And sec­ond, there’s no rush to buy — while house prices could con­tinue to increase, if they do it’s likely they’ll cor­rect back down.

Here’s a link to the RBC report on afford­abil­ity, which con­tains his­tor­i­cal data on twenty cities across Canada: http://​www​.rbc​.com/​e​c​o​n​o​m​i​c​s​/​m​a​r​k​e​t​/​p​d​f​/​h​o​u​s​e​.​pdf

And here’s the sum­mary of long term afford­abil­ity that’s in today’s Globe:

% of typ­i­cal household’s income required to carry an aver­age bungalow

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Tags: 1960s, Canadians, Central Amsterdam, Email, Globe, Historical Returns, Home Ownership, House Prices, House Valuations, Inflation, Last Ten Years, Misinformation, Myth, Phil Soper, Rate Of Return, Robert Shiller, Royal Lepage, School Of Management, Schulich School, Zero Rate
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Expert Evidence to Address Fears About Stocks

Wednesday, February 3rd, 2010

Even with the recov­ery in the last nine months of 2009, many clients are still anx­ious about own­ing stocks.

If you’re run­ning into ner­vous clients, you might want to refer to a recent inter­view with Jeremy Siegel, the Whar­ton aca­d­e­mic who’s the lead­ing author­ity on long term asset class returns.

A link to the full inter­view is below.  Among the key points Siegel makes:

• Stocks today are fairly val­ued based on cur­rent earn­ings – and over the next year will likely offer bet­ter returns than bonds and cash
• Why stocks are likely to be sig­nif­i­cantly higher by 2012
• Infla­tion is not going to be a con­cern in the near to mid term
• The rea­son US deficit spend­ing isn’t the biggest cause for con­cern going forward
• Why the last ten years have been so mis­er­able for stocks – and the rea­son that investors can expect after infla­tion returns of 6 to 7% on stocks going forward

Here’s the full arti­cle: http://​knowl​edge​.whar​ton​.upenn​.edu/​a​r​t​i​c​l​e​.​c​f​m​?​a​r​t​i​c​l​e​i​d​=​2​411

And for clients who’d like to watch Jeremy Siegel talk about his views, below are five short video inter­views he did last Sep­tem­ber that you can email to clients.

Stocks for the long run and long term returns http://​www​.cli​entin​sights​.ca/​v​i​d​e​o​/​s​t​o​c​k​s​-​f​o​r​-​t​h​e​-​l​o​n​g​-​r​u​n​-​a​n​d​-​l​o​n​g​-​t​e​r​m​-​r​e​t​u​r​n​s​/​t​y​p​e​:​i​n​v​e​s​tor

The growth trap and the role of div­i­dends       http://​www​.cli​entin​sights​.ca/​v​i​d​e​o​/​t​h​e​-​g​r​o​w​t​h​-​t​r​a​p​-​a​n​d​-​t​h​e​-​r​o​l​e​-​o​f​-​d​i​v​i​d​e​n​d​s​/​t​y​p​e​:​i​n​v​e​s​tor

Look­ing back on the past ten years in mar­kets – what went wrong http://​www​.cli​entin​sights​.ca/​v​i​d​e​o​/​l​o​o​k​i​n​g​-​b​a​c​k​-​o​n​-​t​h​e​-​p​a​s​t​-​t​e​n​-​y​e​a​r​s​-​i​n​-​m​a​r​k​e​t​s​-​w​h​a​t​-​w​e​n​t​-​w​r​o​n​g​/​t​y​p​e​:​i​n​v​e​s​tor

Today’s val­u­a­tion lev­els and mar­ket out­look   http://​www​.cli​entin​sights​.ca/​v​i​d​e​o​/​t​o​d​a​y​-​s​-​v​a​l​u​a​t​i​o​n​-​l​e​v​e​l​s​-​a​n​d​-​m​a​r​k​e​t​-​o​u​t​l​o​o​k​/​t​y​p​e​:​i​n​v​e​s​tor

The case for inter­na­tional invest­ing       http://​www​.cli​entin​sights​.ca/​v​i​d​e​o​/​t​h​e​-​c​a​s​e​-​f​o​r​-​i​n​t​e​r​n​a​t​i​o​n​a​l​-​i​n​v​e​s​t​i​n​g​/​t​y​p​e​:​i​n​v​e​s​tor

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Tags: Asset Class, Bonds, Deficit Spending, Dividends, Earnings, Expert Evidence, Fears, Inflation, Jeremy Siegel, Last September, Last Ten Years, Leading Authority, Market Outlook, Nine Months, Stocks, Term Asset, Upenn, Valuation Levels, Video Interviews, Wharton
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