The Globe and Mail, Report on Business
Published May 3, 2008

Where were you in August of '82?

I will always remember. I was between my years at Western in what is now the Ivey School of Business and was riding my bicycle down the coast of Oregon with a buddy. Each day I would pick up a USA Today to find out how my beloved Expos had done the night before. Despite my focus on the sports section, I couldn't help but notice that there was a lot excitement about the stock market. It was finally going up.

Little did I know that we were starting one of the great bull markets. Returns over the past 25 years have been terrific, even after you take into account the crash of 1987 and the tech meltdown in the early part of this decade. In a period of subdued inflation, the S&P/TSX composite index and Canadian long bonds both averaged 11 per cent a year.

The question is what should we expect in the future? Will it be more of the same? I think not. The numbers suggest that it's almost certain that returns will be lower in the years ahead.

Before I take you through the math, I should say that this column has not been written in response to the recent weakness in the markets. Indeed, if I wanted to write a column about the current turbulence, it would be more upbeat, focusing on the opportunities that are starting to emerge.

No, my intention here is more long-term in nature and aimed at resetting expectations.

Let's go back to 1982 when George Thorogood was Bad to the Bone, the Canucks were in the Stanley Cup final, the computer was Person of the Year and Lloyd Robertson was reading the news. At that time, interest rates were up in the high teens, price-earnings ratios were down in single digits and dividend yields were around 4 per cent. In hindsight, it was a great time to invest. We all should have mortgaged the house and bought long bonds, stocks and/or more real estate.

But that's easy to say now. At the time, people were worried about rates going even higher and multiples going lower. Nobody expected to make money in the stock market, because they didn't foresee having a 25-year tailwind in the form of declining inflation and interest rates.

Let's now return to the time of Feist, the Penguins, iEverything and well, Lloyd Robertson. Today, the yield on government bonds is under 4 per cent and inflation is showing signs of rising. Price-earnings multiples are in the mid- to high-teens even though they have come down with the recent market weakness. And the dividend yield on the S&P/TSX 60 index is 2.3 per cent. The starting point for the next 25 years is dramatically different than it was in 1982 and is the reason I'm so confident in my prediction.

Now let's take the math further and look at a balanced portfolio that is evenly split between bonds and stocks. The best proxy for future bond returns is the current yield, so we can pencil in 4 per cent for that portion of the portfolio.

Whatever return we project for equities will be wrong, but let's be optimistic and use 8 per cent, which is a premium of four percentage points over bonds. I should note that there is a constant debate in the industry and academia about what the equity risk premium should be. I don't want to go there, but suffice to say it's something like two to five points, not eight to 10 points.

If you add it up, the markets lead to a balanced annual return of 6 per cent, before fees and any added-value from the investment manager or adviser. If inflation doesn't get out of control, it's not too bad a number, but it's a far cry from what people are counting on.

I find too often that investors are still anchored in the world of "just give me 8 to 10 per cent a year and I don't want any big losses."

That's when we as professionals have to find a balance between marketing and setting proper expectations. If we tell investors they are being unrealistic, we risk having them walk down the street to someone who will promise fancier returns.

But if we aren't straight with them, we set them up for certain disappointment, and perhaps even some inappropriate life choices with regard to saving, spending and gifting.

I'm really quite jazzed about the investment opportunities that are going to come our way in the next year or so - oversold stocks, high-yielding corporate bonds, Arizona real estate and the remains of broken acronyms. But that excitement comes in the context of a realistic long-term outlook, not "8 to 10 per cent with no downside."