The Globe and Mail, Report on Business
Published August 4, 2007

At some point in the next year or two, it is going to get much harder to be an investment professional.

A significant market decline and/or bursting of the liquidity bubble would certainly contribute to such a period, but I’m referring specifically to the challenge advisers and managers will have in dealing with the inflated return expectations that investors now have.

For Canadian investors over the last few years, generating healthy returns has been like shooting fish in a barrel. Even if you weren’t perfectly positioned in the hot sectors, your domestic returns have been fabulous since the market started to rise in early 2003. More balanced portfolios with bonds and foreign equities haven’t done as well, but have still been good.

With a good market that has gone on for a while comes higher expectations for future returns. Given the ebbs and flows of the stock market, you’d think it should be the other way around, but it isn’t. People get dialled in on what their returns have been recently and that is the new standard for what they expect going forward. Obviously, I’m referring to investors in general when I make these statements, as many seasoned investors don’t think this way and have the equation right.

Investor expectations have come full circle from where we were in the late 1990s.

In the fall of 1999, investors were jumping through the moon. At the time, I was newly minted president of money manager Phillips, Hager & North and we were starting a campaign to engage our clients in a discussion about future returns. We methodically took them through the three components of equity returns – profit growth, dividends and change in valuation. While the return of the S&P 500 had been 18.4% from 1982 to 1998, we suggested that future returns would be more in the order of 8 per cent.

Our assumption about profit growth was slightly higher than the previous period, but we budgeted for 1999 yields of 1 per cent (as opposed to the juicy 3.9 per cent available in 1982). Change of valuation refers to an increase or decrease in the price-to-earnings multiple of the market. We suggested that at best the P/E multiple would hold flat and therefore add nothing to future returns.

Some of our clients appreciated the effort, but many thought we were out of touch with reality.

Jumping ahead to 2003, we had the opposite challenge, but got a similar reaction. Investors were finishing up their third year of a pretty ugly market. As of March 31, the three-year return for the S&P/TSX Composite Index was a loss of 11 per cent a year. At that point, the expectations pendulum has swung to the other extreme. Investors were expecting little or no return from equities, while our long-term outlook was still 8 per cent.

I went a step further in an April, 2003, commentary by suggesting that double-digit returns were a distinct possibility in the next few years given how depressed the market was. I said that “investors should be more greedy than afraid.”

Unfortunately, many of our clients thought we were raving optimists.

Where are we today on the greed versus fear meter? It’s hard to say, but in talking to clients and prospective clients of Steadyhand, I sense that we are solidly on the greed side. Investors have just looked at their June statements and seen that many of their equity funds have been averaging 20-per-cent-plus returns for four years.

There are some reasons to believe the investor expectations pendulum won’t swing as far this cycle. While investors generally have short memories, this round trip has happened in just eight years.

There are also lots of voices now recommending caution (including mine). John Thiessen at Vertex One is one of those voices.

He points out in his quarterly commentary that with risk-free assets yielding 4.5 per cent, it would be an achievement to generate a return above 7 per cent on a [balanced] portfolio. He also warns, however, that “most investors today would consider 7 per cent a substandard return and...would be laughing out loud.”

Personally, I’ve been fighting the surrounding euphoria and making sure my portfolio is positioned cautiously. In other words, I own fewer stocks and equity funds today (as a percentage of total portfolio) than I did in 2003.

In all honesty, it was a year-and-a-half ago that I started shading my portfolio in that direction. I don’t know when the joyride is going to end, but I’m a believer in being approximately right as opposed to exactly wrong.

As Mr. Thiessen of Vertex says: “Returns come in a most unpunctual fashion - they disappear unpunctually as well, but also more rapidly than they arrive.”

So investment managers and advisers are going to earn their money in the next few years as client calls and meetings will no longer be love-ins.

If they haven’t made any effort to temper expectations, those calls could be downright ugly –as in: “You’re fired.”