Sunday, May 10, 2015

How come I don’t make 14% per year like the Gurus or the ETFs?

What is a realistic return on investment?  How come I can’t make the returns so many of the stock market Gurus claim to achieve? Well first of all, you only hear of the Gurus that do well right now. ‘Gurus’ that have poorer returns you don’t see on BNN. Secondly, the gurus only quote the returns on a particular stock or one of their many different portfolio models. You have only one model. You should never forget that BNN is an advertising channel that only reports with sensationalized headlines. Everything is depicted in extremes and you have constant the feeling you’re missing out on something if you don’t buy the latest top picks or follow their ‘market call tonight’ religiously. 

Reality is that 80% or so of those managers do not outperform the markets, because to some degree they make the market and their average performance equals that of the market minus commissions and various fees including management fees. Then you wonder, but I don’t make even what the market ETFs make!  Well, I can help you out there as well. The market ETFs do not include your cash and other holdings in various other asset classes. For example, say the Dow goes up 15% this year and so does, more or less, you Dow Jones Spider ETF. But your portfolio holds also cash that makes nothing.  Say you hold 10% cash.  90% ETF at 15% PLUS 10% cash at 0%= 13.5%.  Oh my God, you’re under performing! J
To make matters worse, you know that proper asset allocation tells you that you need 40% in fixed income.  Yeah right!  You need proper asset allocation!  Ok say 55% stocks and 10% cash and 35% Fix Income.  Fixed income has what return?  1%?  Let’s be generous let’s say 4% return.  So now you’re making 55% x 15% and 10% x 0% and 35% x 4%. OMG your return is only 10%! You must be a terrible investor!
Well let’s think a bit more!  If the ‘No Risk (yeah right)’ money, i.e. a 5 year Government Bond pays 1% and if a stock like Royal Bank yields 3.9% not to forget annual appreciation or if the overall TSX index yields 2.6% (plus appreciation) , where would you invest?  Oh… and the interest is taxable at you top tax margin say 45% and your dividend yield is taxable at 30% - ooh and your dividend typically goes up with inflation and your interest does not. Where in would you invest?
So let’s see. Currently our inflation is around 1% annually.  So I am making 1.0% interest for locking my money in for 5 years and every year I lose 1% in purchasing power and pay 45% taxes on that one percent interest. Thus in real purchasing value, my no-risk Government Canada bond loses nearly 0.5% per year in purchasing power!  Would you be happy then with a stock investment that returns you 6%? Or 5% after inflation or 3.2% after taxes and inflation?  Would you take even less? Say 2% after taxes and inflation?
Well, assuming your stock price is entirely rationally priced to reflect earnings per share; then a 6% earnings yield (dividend plus appreciation/stock price) equals a P/E of 16.7 (1/earnings yield). At 4.3% earnings yield (2% after tax and inflation) the P/E would be 23.26.  So when people say that the U.S. stock market is over-valued today (P/E 20.68 for S&P500) because it is trading above the historical average P/E of 14.5 would you agree?  Yes in 1984 the S&P was trading around a P/E of 14.5 but interest rates were close to 10% and inflation was around 8%!
The average historical Canadian inflation rate hovers around 3-4% (it changes since we have experienced now close to 10 years of inflation below 2%). If you want to break even on your 5 year Government bond it should pay 6.4% interest.  When was the last time you saw Government of Canada bonds yielding around 6.4%  and in terms of mortgage rates (which are based on the 5 year bond rate) of 8% (the banks need to make a profit after all)? But I digress… ahmm.
So now let’s see what your return is going to be in a truly diversified portfolio with real estate and gold?
Since the peak of Gold prices in 2011, returns on Gold have been negative.  IF you bought Gold in 1982 at $1000 per ounce and sold it in 2011 at $1895 your Return on Investment (ROI) before taxes was 2.1%; after taxes and inflation it would have been -2%.  If you were a contrarian and bought around 1994 at $200 per ounce, your return was 14.1% or 7.5% after taxes (capital gains taxes) and inflation. In 1970, Gold was $200 and it peaked in 1982; maybe we should check the returns from 1970 until the 2011 peak to get a better feeling for long term returns: ROI=5.6 and 0.9% after tax and inflation. OK so long term gold does protects you kind-off against inflation but you still have to buy it at pretty low prices.   If you diversified into Chaos Hedges such as gold and silver, and you truly returned 5.6% per year your overall portfolio return is: 9.2% (50% stocks, 10% cash, 35% fixed income, 5% Gold).  You could argue that if you had invested only since 2011 in Gold your return would have been -12% and your overall portfolio would have been 7%. 
Now, let’s add the last major asset class: Real Estate. Real Estate over the last 30 or 40 years appreciated at 4.5% in Calgary. The cap rate was around 3.5%.  Assuming no leverage your annual return would have been 8% or on an after tax and inflation (4%) basis: 2.07%.  So, let’s simulate a portfolio with 40% Real estate; 33% Stocks; 12% fixed income; 10% Cash; and 5% Gold (and silver).  Now your return would be 8.9% if you would substitute historical fixed income returns of 4.5% and a stock market returns of 11% rather than the Guru’s boisterous 14%, your long term portfolio return would be 7.6% and this is before taxes and inflation!
Really, I threw a lot of numbers at you. But you can see that you should not benchmark your portfolio performance to an ETF stock market index. There are many other factors involved when you measure your overall portfolio performance. Over the long term, your portfolio should grow by 7.6% plus your annual savings (from your salary either from your business or your employment).

BTW. Do you really believe that tax increasing governments are your friend? Or are they increasing their bureaucratic empires at your expense?  This is why I love the TSFA and the TSFA maximum contribution increase to $10,000!  It is one of the few ways you really can save for a retirement - poor or rich; young or old.  RRSPs are robbing successful savers/investors because it assumes that after 65 years of working you are in a lower tax bracket than during your 'earning years'!  You call that success being in a lower tax bracket when you are in your 60s than when you were 20 or 30 years old?

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