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How To Think About Passive Investment Performance

Michael Marco is Director of Investment Research at Wealthsimple. Michael began his career as an Investment Associate at Bridgewater Associates, researching equities strategies and leading a team to provide strategic investment advice to large institutional clients. Prior to joining Wealthsimple, Michael led investment research and development efforts at an alternative-data hedge fund. Michael holds a B.A. from Yale and a J.D. from NYU.

One of the biggest mistakes investors make is basing decisions on recent performance.  This can mean buying more shares of a stock that has shot up, or selling shares after the price has plummeted. Research has shown that, more often than not, this “performance-chasing” behaviour can be very harmful.

Why do investors do this?  It may be because they don’t understand the volatility they should expect in the short term to reap gains in the long term.  To help our clients avoid this trap, we’ve created a three-step framework for thinking about performance for long-term “passive” portfolios like ours, which are not designed for active trading.  They are designed with the aim of growing your money gradually over time.

  1. Set Your Time Horizon and Risk Tolerance — The longer you can stay invested, the more unlikely it is that you’ll end up with a meaningful loss, even with risky portfolios.  If you need the money sooner and want to reduce the risk of loss, consider safer portfolios.

  2. Set Expectations.  You need to know what kind of volatility to expect in the short term and why — especially for losses.  Returns over time should be roughly proportional to the risk you take, but it’s not uncommon to lose 10%-20% in a single year when the markets take a downward turn.  On rare occasions, riskier portfolios can lose much more.  Expect a wide range of outcomes in the short term, but know that that this should even out over time. You will likely lose money in roughly one out of every three years — which means you will probably make money in the other two. 

  3. Evaluate Performance vs. Expectations.  Look at performance in the context of history and what is happening in global markets.

This framework will help you stay on track and avoid making bad decisions that could hurt in the long run.  The biggest takeaway?  Be patient.  It’s critical to be able to stay the course through ups and downs in order to be successful.  

1. Set Your Time Horizon and Risk Tolerance

 The following chart shows, big picture, what the chances of a 10% loss would have looked like historically for each of the portfolios going back to the 1920s, adjusted for today’s low level of interest rates.  As you can see, the risk of loss is higher in the short term but falls over time.

For the growth portfolio, the probability of losing 10% or more is still relatively high at the 5-year mark — about 15%.  After 10 years, that probability drops to 5-6% and falls further from there.  For the conservative and balanced portfolios, the probability of a material loss starts to dip below 5% around the 4- to 5-year mark.  Note how the probability rises before it falls. While there is some probability of having a couple bad years in a row, having many bad years in a row is pretty unlikely. (And don’t forget, the probability of positive returns after 5 years is far higher than the probability of losses — from 74% for the growth portfolio up to 84% for the conservative.)

For additional information on this chart, see the Disclosure and Note 1 in the Disclosures section below.

Of course, no one knows the true probabilities — these are just historical averages — and the future could look very different from the past.  But we think history is a pretty good indicator of how long you should plan to stay invested for each portfolio.

So, how long can you stay invested?  How much short-term pain are you willing to experience for long-term gain?  Make sure you’re clear with yourself about your answer and choose the portfolio that’s right for you.

For illustrative purposes only.  Portfolio suitability will vary from person to person based on individual circumstances.  Consult your advisor or ask Wealthsimple for further information on what portfolio is right for you.

2. Set Performance Expectations

To evaluate performance in a smart way — both short term and long term — you need to set clear expectations.  First, it’s critical to be comfortable with the range of potential outcomes in any given quarter or year — i.e., how often the portfolio will lose money and how big those losses might get.  Second, it's important to understand what drives performance, so you can make sense of your results.

Expect a Wide Range of Outcomes

With most portfolios, you should expect a wide range of potential outcomes in the short term that will even out over time.  The riskier your portfolio, the higher the expected return in the long run — but the bigger those short-term swings will be.  To get a sense of the range of outcomes to expect, we look again at how markets have performed in the past.  The following chart shows the range of annualized returns you could have experienced over 1-year, 3-year, 5-year and 10-year timeframes again going all the way back to the 1920s, and adjusted to reflect today’s lower expected risk-free rate (about 1%).

For additional information on this chart, see the Disclosure and Note 2 in the Disclosures section below.

As you can see,  the riskier the portfolio, the more volatile the returns.  This is to be expected: a growth-focused portfolio will experience wider swings than a conservative one.  Also, returns are most volatile in the short term (1 year) — they could be very high or very low — and become smoother and more consistently positive over time (10 years).  It’s worth noting, however, that even at the 10-year mark and beyond, a wide range of outcomes is possible.

The following tables zoom in on short-term performance.  They show a “typical” quarter and year for each portfolio, as well as the best (top 10%) and worst (bottom 10%) of quarters and years.  Notably, 30% of years are negative.  That’s normal.  A bad year can easily mean a loss of 10%-20% or more, depending on the portfolio.  Of course, the good years can be very good, and over time, history shows us that there are more good years than bad.  Using the same simulation as above, here is the simulated range of returns.

For additional information on these tables, see the Disclosure and Note 3 in the Disclosures section below.

In summary, you should expect a wide range of outcomes in the short term even for the conservative portfolio, and especially for the growth portfolio.  This volatility is an inherent part of taking risk to earn positive returns over time.

Economic Conditions Drive Returns

If part one of setting expectations is knowing what level and range of returns to expect, part two is understanding what drives those returns.

In the short term, returns are connected to economic conditions and how monetary policy — e.g. how central banks raise or lower interest rates — unfolds relative to what markets expect.  If markets expect economic growth to be strong and it’s weak, stocks will likely decline and bonds should rally.  If inflation is supposed to rise but it rises less than expected, we’d expect both stocks and bonds to do well.  If inflation soars, both stock and bonds will likely do poorly. If monetary policy is easier than markets expect — interest rates are low and it’s easy for people and companies to borrow money — both stocks and bonds should do well. In contrast, if monetary policy is tighter than markets expect, both stocks and bonds should suffer.

Your portfolio’s short-term performance will be driven by its mix of assets.  For a growth portfolio, most of the assets — roughly 80 percent — are in stocks.  Since stocks are generally much riskier than bonds, this means growth will be a major driver of returns.  A conservative portfolio, in contrast, balances risk between stocks and bonds, so that portfolio should be less exposed to changes in growth. 

Over time, short-term changes in expectations for growth, inflation, and monetary policy shouldn’t matter very much, as they tend to wash out.  Sometimes they’re surprising on the upside, other times on the downside.  But these forces are known risks that are important to understand because they help you make sense of your performance.

For more information on how growth, inflation, and central-bank policy drive performance, see Appendix A of our portfolio construction white paper here.

3. Evaluate Performance vs. Expectations

The next step is evaluating your portfolio’s performance.  For a long-term passive strategy, it is important not to check performance too frequently.  Research has shown that, at least in experimental settings, investors who evaluate performance most frequently “took the least risk and earned the least money.”  This is because all that checking in led investors to panic over short-term losses and make unwise decisions to sell when they should have just waited out the downturn.  Evaluating your portfolio once a quarter (at most) strikes a reasonable balance between the need to know how you’re doing and there being enough new performance information to make checking in useful.

Keep Performance in Perspective

First, it’s critical to evaluate performance in the context of history.  That means not just looking at how well or poorly your portfolio performed in the quarter, but also how it did or would have done in previous quarters, as far back in time as you can go.  This will tell you what a “typical” quarter looks like.

The following chart shows the quarterly performance of Wealthsimple’s growth portfolio each quarter since inception in 2014.  90% of the time, performance should fall within the two bands shown, but one in 2 to 3 years or so (1 in 10 quarters), we expect returns to fall outside those bands.  So the odds you’ll have a quarter that’s higher or lower than 90% of the historical outcomes are pretty good — in fact they’re 10%.  But the odds that you’ll have 3 or 4 such quarters in a row are very low — less than 1%.  This kind of context can help put a recent gain or loss in perspective.

For additional information on this chart, see Note 4 in the Disclosures section below.

While performance may fluctuate widely from quarter to quarter, the portfolios have historically provided attractive returns over time.  This last chart shows cumulative performance against the range of outcomes we’d expect based on long-term historical volatility and returns of similar portfolios.  The portfolio has performed in line with expectations.

For additional information on this chart, see Note 5 in the Disclosures section below.

Understanding What Drove Performance

So why did assets perform the way they did?  Did growth expectations improve over the quarter?  If so, we’d expect stocks to rally.  Did the Fed unexpectedly cut interest rates?  If so, we’d expect bonds to rally, and likely stocks as well.  Part of evaluating performance is confirming that the portfolio is behaving the way you would expect given what’s happening in the world.

Conclusion

To get comfortable with your performance, you need to:  (1) make sure you’re in the portfolio that’s right for you given your time horizon and risk tolerance, (2) expect a wide range of outcomes in the short term, and (3) evaluate performance in the context of your expectations and understand the economic drivers behind it.  If what you experience is in the realm of what you expect, and it makes sense to you, you’re more likely to stay the course.

We hope this guide to thinking about performance helps you keep things in perspective the next time you see a dip in returns — even if it’s a big one!  As always, reach out if you have any questions — we’re happy to answer them.


Disclosures

  • Sources:  Global Financial Data, Xignite data, Wealthsimple analysis

  • Disclosure:  All charts and tables are shown for illustrative purposes only and are not the returns of an actual account.  Long histories of returns are for simulated portfolios of global equities and Canadian 10-year bonds over the Canadian 3-Month T-bill rate since 1925 plus an assumed cash rate of 1%, less Wealthsimple’s management fee (0.50%) and assumed ETF fees of on average 0.15%, and a 0.03% annualized foreign-currency conversion fee, and weighted as follows: conservative (35% equities, 65% bonds), balanced (50%/50%), and growth (80%/20%), assuming monthly rebalancing and before transactions costs.  Past simulated performance is not necessarily indicative of future results, actual allocations differ and actual performance and probabilities will differ.

  • Note 1:  This chart reflects frequencies of losses of different magnitudes for the simulated portfolios. 

  • Note 2:  This chart reflects the range of annualized returns for the simulated portfolios.

  • Note 3:  The tables show the historical results of the portfolio simulations.

  • Note 4:  Source: Xignite data, Wealthsimple analysis.  The chart of growth portfolio quarterly returns shows the simulated returns of Wealthsimple's growth portfolio using Wealthsimple target allocations through time and Wealthsimple's threshold-based rebalancing logic, net of an estimated 0.5% management fee, 0.15% weighted-average ETF fee, and 0.03% annualized foreign-currency conversion fee where applicable, before other transactions costs. Returns shown do not reflect the performance of any account traded by Wealthsimple and actual account returns may vary due to differences in timing, dividend reinvestment, trading costs, tax-loss harvesting, foreign-currency fees, taxes, and other factors. Returns shown reflect registered account (RRSP) allocations; actual allocations may vary by account type. Past performance is not necessarily indicative of future results. Probabilities are unknowable, actual probabilities may differ, and future performance may differ materially from expectations.

  • Note 5:  Source: Xignite data, Wealthsimple analysis.  The chart shows the total returns net of fees of a representative growth portfolio account since inception calculated as described in Note 4 vs. cumulative long-term expectations that assume long-term volatility of 10%, expected returns of 4% above cash, a 1% cash rate and a normal distribution of returns adjusted to account for fat tails present in markets.  Not the returns of an individual account.  Past performance is not indicative of future results and individual account performance will differ.

Last Updated December 3, 2019

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