What to Expect When You are Investing

As an economist, I can tell you that forecasting is easy – it’s the accuracy part that’s hard! When there are so many different views on where the markets are headed, how does an investor know how much they need to save to achieve their goals?

If we look at the Canadian investing landscape from 1900 to 2016, stocks have been by far the best investment, returning close to 6% per year in real terms (after inflation), compared to real returns of only 2% per year for bonds. This is the traditional risk-return trade-off investors are accustomed to: Hold bonds for steady, but not spectacular returns, hold stocks for higher long-term gains.

Even though that relationship held true over the period as a whole, the past few decades were an exception. Bonds actually outperformed stocks during both the 1980-1999 and the 2000-2016 periods. These were years of dramatic declines in interest rates, which boosted the return on holding bonds. During the past 16 years, stocks returned 4% annually in real terms, while bonds earned 5% as interest rates dropped.

As all bondholders know by now, that party is over – as bond yields are hovering around 2% currently.  The good news, however, is that inflation has been truly tamed. In Canada, our central bank has been very successful at keeping inflation low, and it’s a safe bet that inflation will stay near the midpoint of the central bank’s target range of 1-3% over the longer term.

As an investor with a 20-year time horizon, what rates of return would I count on for planning purposes? Taking a look at the entire period from 1900 to 2016, not only in Canada but globally, stocks outperformed bonds by a wide margin, and I’d expect that long-term trend to hold. Would I count on real returns of 6% per year on stocks to continue? Perhaps not, but 4-5% annual real returns for stocks seems reasonable. For bonds, I’d plan on long-term real returns of only 0-1%. Bringing these numbers up to nominal terms, building in an inflation rate of 2%, this would mean nominal returns of 6-7% per year on stocks and 2-3% per year on bonds over the next 20 years.

What’s the lesson for investors?  Thinking about what is sustainable over the longer term makes us temper our expectations. After a long stock market rally, history tells us that we are due for a correction, but history also reminds us that there will be a rebound before too long. That’s the closest this economist is getting to forecasting the stock market!