Stock indices at record highs, interest rates at record lows. What to expect? What to do?

In the early 1980’s the prime lending rate peaked at over 20%.  Since then the trend in the main benchmark rate in Canada and other developed economies has generally been down, leading to strong price returns in bonds over that period.

With some fairly memorable bumps along the way stocks have also performed quite strongly over the same period.  As a result, any well diversified balanced portfolio has done well over the long term.  In fact there has been less performance difference than you’d think between a bond heavy balanced portfolio and one that’s stock heavy.

So now that global stock indices are at record levels and interest rates near record lows, what can we expect for future returns?  This month McKinsey and Co. published a report suggesting that investors may want to temper their return expectations going forward for the following reasons:

From Why investors may need to lower their sights | McKinsey & Company

“forces that have driven exceptional returns are weakening, and in some cases reversing. The big decline in interest rates and inflation is reaching its limits, global GDP growth will be lower as populations in the developed world and China age, and the outlook for corporate profits is cloudier. While digitization and disruptive technologies could boost margins for some companies, the big North American and Western European firms that took the largest share of the global profit pool in the past 30 years face new competitive pressures from emerging-market companies, technology giants, and digital platform-enabled smaller rivals. These forces may curtail margins going forward.”

This chart summarizes the results of their analysis:

Now that doesn’t sound very promising for people just starting or even well into their investing journey.  We’re  always skeptical of market forecasters’ ability to make predictions and you could have made similar predictions with the same arguments 5 years ago and been dead wrong.   That said, McKinsey isn’t Jim Cramer and as a general rule it is prudent to use conservative estimates for investment returns when planning for the future.  So again, McKinsey doesn’t know what’s going to happen anymore than anyone else.  However, if their conclusions persuade you to be more conservative when thinking about future investment returns, it might help you manage your expectations and adjust your financial plans accordingly.  You might need to save more, adjust lifestyle now and in the future, and possibly even think about taking on more risk in your investment portfolios, especially if you hold too high a proportion of cash or GICs in your portfolio. But this point about taking on more risk in order to generate higher returns in a new low returns environment is where you have to be most careful.  One of the most common pieces of advice we read these days is that you need to shift your asset mix more towards equities from bonds and to more risky bonds in order to seek higher investment returns in the future.  This MoneySense interview pretty much encapsulates the kind of advice we’re talking about.

“To ensure a sustainable income, retired investors need to own more stocks and higher risk fixed-income vehicles than they used to”

Sure it’s a lot less painful to make a few changes and ramp up the risk in your retirement portfolio than it is to actually take a hard look at your finances and curtail your discretionary spending, but doing so could also set you up for catastrophe.

The reason to hold bonds in your portfolio is to enhance the safety and stability of your investments.  Returns from bonds are less volatile than those from stocks and tend to be uncorrelated with stock returns when it actually matters.  Shifting your allocation away from bonds and into stocks and increasing the risk on the bond side of your portfolio by seeking bonds with lower credit quality can defeat the purpose.  People argue that interest rates are so low so bonds are a terrible investment.  This argument ignores the protection that bonds give you in a stock market sell off – that is why they are there.  It also ignores the fact that risk tolerance is a very personal thing. Tilting your portfolio towards more risk can mean you won’t be able to stomach a short term drop in the market because your portfolio isn’t attuned to your psychological ability to weather market turbulence.

Changing portfolio allocations isn’t the only way to improve the prospects for your future financial situation. Sensible financial planning considers many more aspects of your financial situation and life goals.