Dec 21, 2021

High hopes for future returns can cloud an investor’s judgment

It’s been another outstanding year in the stock market. We will have the final performance numbers for you in the new year, but equities have continued a remarkable run that started in March 2020 when the COVID crash hit bottom.

While the strong results are certainly welcome, they appear to have conditioned many investors to hold unrealistic expectations about their future investment returns.

That’s the key conclusion from a survey of 8,500 individual investors in 24 countries and 2,700 financial professionals in 16 countries conducted by Natixis Investment Managers, a French financial services firm with US$1.4 trillion under management.

The survey found a huge gap between the returns individual investors expect to earn over the long term and what financial professionals say is realistic. Globally, investors anticipate annual returns of 14.5% over inflation while the financial professionals said 5.3% over inflation is realistic—that’s a whopping 174% difference.

Canadian investors were somewhat more conservative than their global peers, according to the survey. Individual investors in Canada expected annual long-term gains of 11.2% over inflation while financial professionals believed realistic returns for their clients were 5.1% a year.

By contrast, U.S. investors were even more aggressive in their return expectations than the global average. American investors anticipated 17.5% annual returns above inflation compared with the 6.7% financial professional said is realistic.

The research team at PWL uses an evidence-based approach for setting expectations for future returns for various asset classes and inflation. In our Financial Planning Assumptions paper, published in October, we estimated expected annual returns from a 60/40 equity/bond portfolio to be 4.86% above inflation.

Why are investors so optimistic about future returns? We can attribute it to what’s known as recency bias—a common error in thinking that leads people to give greater importance to recent events.

Clearly, many investors have grown accustomed to excellent portfolio performance. Even before the powerful rally that began in the early weeks of the pandemic, returns had been strong ever since the 2008-09 financial crisis. This has led them to expect it to continue and get even better in the future.

In the Natixis survey, investors identified market volatility as their No. 1 concern, yet their elevated return expectations suggest they’ve become desensitized to risk. We see this in a growing appetite for risky investments such as tech stocks, cryptocurrencies and special purpose acquisition companies (SPACs).

However, capital market history, valuation metrics and common sense suggest we should be tempering our return expectations after such a long period of exceptional performance, not ratcheting them up.

We are careful to control risk for our clients through broad diversification and periodic portfolio rebalancing. No one can predict what the future holds, but a patient, realistic view is the best way to build wealth over the long term.

As the year comes to a close, Francois and the whole PWL team join me in wishing you a happy holiday season and a healthy and prosperous 2022. We look forward to reviewing your portfolio with you in the new year.

James Parkyn
James Parkyn

James is a founding partner and Portfolio Manager at PWL Capital Inc. in Montreal with over 25 years of experience helping clients achieve their financial goals.

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