Wealth Watch: Have a plan because negative returns are part of investing

Derek, is it reasonable to expect negative returns from my investments?

Although most investors have hopes for big returns, the looming possibility of a bad year should always be in the back of their mind. This doesn’t mean that investors should run to the hills every time the stock market has a bad day, but it should be a reminder that expectations are extremely important when making investment decisions.

If you have an expectation that your investment should never decline in value, you limit the types of investments available to you and quite possibly the returns. If you can only handle guaranteed rates of return, you should focus on ultra-low risk investment products like Guaranteed Investment Certificates (GICs), or even cash. At that same time, be aware what inflation may do to your overall long-term returns. Said another way, money in your mattress may not have the same value after ten years.

Assuming you’re willing to take on even a small risk, you need to consider the time frame when understanding how to judge performance and thus make an effort to gauge the reasonability of negative returns.

The standard time frame for investment performance tends to be periods of one year, three years, five years, and 10 years. This is intended to provide investors with a uniform approach for comparing investments. Some investors flock to calendar year performance, which is helpful, unless of course you weren’t invested over the entire year. Ideally, you should also focus on after-cost (net) performance. With all this information in hand, we can start to determine whether investors should ever expect negative returns.

The reality is that the majority of investments can produce a negative rate of return over short time frames. The longer this time frame becomes, the more likely it will be that the negative return either diminishes or disappears. The thinking is simple. If you invest in the stock market today and sell tomorrow, there is a high chance that you could have a negative return. The same can be said if you wait a week, or even a month. Once you extend this time frame to one year there is a lesser chance, although still quite possible. Finally, once you get to three years, five years, and ten years it becomes less and less likely that you would have experienced a negative return.

So the question then becomes, what is the reasonable amount of annual negative returns one should be willing to expect over a longer time frame? The answer is unique to your investment plan, but can be expressed as a rising number that coincides with the more you have in equity-based investments. Said another way, a portfolio that only holds stocks should expect more negative returns than a portfolio that only holds bonds (and yes, bonds can generate a negative return as well – perhaps another article in the future). With this in mind, it’s not unreasonable to think that a balanced portfolio may generate negative returns once every five to seven years.

The trade-off here is always about returns and risk objectives. If an investor is seeking larger gains, they should in turn be able to accept more fluctuation in the value of the portfolio (including negative returns) and maintain a focus on the long-term performance. Short-term movements can be volatile and can lead investors to make poor decisions. Sometimes these poor decisions means the negative performance becomes permanent rather than short-term.

Typically the best course of action is to accept that there will be negative returns over the long-term in an investment plan. The point is that you should build a portfolio that can stand these periods and soften the fluctuations. A well-thought out and diversified portfolio doesn’t mean you run to cash every time the market takes a blip. In most cases, the best thing an investor can do is embrace these volatile periods as part of their plan and focus on the long-term.

Finally, I suggest that investors should expect negative returns and have a plan in place as to what they will do when this inevitable time comes. I also strongly recommend that investors seek guidance from a qualified Wealth Advisor prior to making investment decisions.

Happy investing,

Derek Fuchs

Senior Wealth Advisor

Scotia Wealth Management

This is for information purposes only. It is recommended that individuals consult with their financial advisor before acting on any information contained in this article. The opinions stated are those of the author and not necessarily those of Scotia Capital Inc. or The Bank of Nova Scotia. Scotia Wealth Management is a division of Scotia Capital Inc., Member Canadian Investor Protection Fund.

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