Plan for past returns and you will lose

Olympic hurdlers have it pretty good. Every four years they race around in front of the cameras and everyone claps when they cross the line. It would be an utter disaster for them if they turned up on the day to find the hurdles were set twice as high as the rule book stated.

But that would never happen. (Sadly for us, because it would make great television.)

Investors, believe it or not, are a bit like hurdlers. If their expectations of returns are realistic, they will probably hit their savings targets.

But what happens when the rules change? That is where investors find themselves today, and if they don’t adapt they won’t make it to the finish.

DON'T LOOK BEHIND YOU

Anyone whose investment savings target relies on a return to the era of double-digit returns is deluded. To avoid disappointment they need to lower that expectation, rebalance their portfolio or push back their plans for spending, including retirement. Expectations have changed, particularly for defensive assets.

The table shows average returns for the major asset classes for the past 25 years compared with InvestSMART’s forward-looking estimates.

These subtle revisions in outlook will have a dramatic effect on possible future balances when the all-powerful variable of time is left to do its thing. Here is an example of how your typical portfolio split 70:30 between Australian equities and Australian bonds will track.

The blue line shows the outcome based on the hope that what’s gone before will happen again, but the red line accounts for returns for Australian bonds being 2.2% for the future, instead of the 5.7% a year on average enjoyed over the past quarter century.

Some investors may need to sit down and question their allegiance to defensive assets.

SELF-MANAGED AND FINGERS CROSSED

Now let’s look at the allocations for your average self-managed super fund with a balance around $500,000. Using a broad brush, such a DIY super fund would be expected to have 60% in Australian equities (where direct shares and managed investments are included), 10% in property and 30% in cash. 

In this case lower expectations for all three asset classes are bad news for any backward-looking investor. More than anyone else SMSF trustees have to be honest with themselves. They are planning for future income at whatever appropriate level, but that can only be generated by an appropriate amount of capital. If expectations for returns are lower than their personal estimates, they have to ask whether they are hoping for too much — and why.

IN BALANCE

Finally, how would a portfolio equally weighted between the six investment classes be affected by shifting from historical returns to forward-looking estimates? It’s not good news.

BACK TO THE DRAWING BOARD

Hopefully most self-directed investors will have realistic expectations for whatever lurks within their portfolios. If it turns out their hopes are a little high, however, all is not lost — maybe it’s time to accept a little more risk in your strategy. As we’ve written about here before, it turns out the case for increasing allocations to defensive assets as you grow older isn’t as strong as many believe.

If it looks like reaching your goal will require you to take on a little bit too much risk, it would then make sense to ask yourself if that target of yours is a little too high. Maybe you can get by on a little less when the time comes? Either that or push back your plans by a few years. Enjoy the present. It’s a gift!