Risky business

Historically low interest rates. Modest growth. Lower return expectations.

October 26, 2017

It all adds up to one of the most oppressive investing environments in history. And we’re in it right now.

Question: What would an investor need to do to achieve a 7.5% return with the least amount of risk possible?

That’s the question a pair of exceptionally smart investment researchers at the Callan Institute – part of Callan Associates Inc., a U.S. based investment advisory firm headquartered in San Francisco – attempted to answer in September 2016, as part of a report called Risky Business.

Using Callan’s proprietary forward-looking market projections, the researchers — Jay Kloepfer (Executive Vice President and Director, Capital Market and Alternatives Research) and Julia Moriarty (Senior Vice President, Capital Markets Research) — discovered that investors in 2015 needed to accept three times as much risk to achieve a 7.5% return compared to the risk level they confronted in 1995.

It wasn’t that long ago

Back in 1995 a portfolio made up entirely (100%) of fixed income investments was, according to some publicly available measures, projected to deliver a return of 7.5%.

Now, according to the Callan Institute, that fixed income portion is down to 12%, with private equity and stocks making up around 75% of the portfolio.

Risk optimization

According to the Callan Institute, they routinely conduct asset allocation studies for clients in order to determine the risk associated with portfolios that are designed to generate an expected return.

They use an optimizing tool that helps them find the efficient frontier, meaning the right combination of assets that provides the highest return for the lowest risk.

In 1995, their expectation for broad U.S. fixed income was exactly 7.5%. They found a 100% fixed income portfolio was an efficient way to achieve that return, with a standard deviation of just 6% — see chart below.

Projected portfolio returns over past 20 years

  1995 2005 2015
Bonds 100% Bonds 52% 12%
U.S. Large Cap 20% 33%
U.S. Small Cap 5% 8%
Non-U.S. Equity 14% 22%
Real Estate 5% 13%
Private Equity 4% 12%
Expected Return 7.5% 7.5% 7.5%
Standard Deviation* 6.0% 8.9% 17.2%

Source: Callan Capital Market Projections
* Likely amount by which returns could vary

As you can see, just 10 years later an investor seeking a 7.5% return would have needed a portfolio containing 48% relatively risky, return-seeking assets, with just 52% in fixed income.

Between 2005 and 2015 an investor had to elevate the risk in the portfolio even more and include 88% in return-seeking assets, with just 12% in fixed income.

Likely amount by which returns could vary

Take a look at the ‘standard deviation’ entry in the chart. Standard deviation is, as many of you know, a widely accepted measure of risk.

According to the Callan Institute calculation, the risk required for the delivery of a 7.5% return nearly tripled from 6% to 17.2% during the period 1995 to 2015 — an unsettling conclusion, as I’m sure you’ll agree.

A word of warning. The asset mixes contained in the chart included with this blog were generated by the researchers at the Callan Institute, not by me. They are both speculative and illustrative, though grounded in a high degree of reality.

Still, getting the asset mix in your portfolio properly balanced to deliver optimal returns is a conversation I have with my clients virtually every day. I’m available to have one with you.

Geoff Funke, Senior Wealth Advisor, Scotia Wealth Management, 604.535.4721