An index update

Reduce your risk exposure as you head toward retirement by following a simple rule of thumb.

Let's face it, these are worrying times for investors. Interest rates are almost at an all-time low and the stock market has been trending lower while fluctuating wildly in the process. The past decade has not been kind to savers no matter what their investment strategy.

And that’s a problem when it comes to saving for your retirement because the last decade before you retire is the most important one in terms of how well your investments perform.

Let’s touch on asset allocation. You had to make a decision about what portion of your portfolio to put in equities versus fixed income. The mix determines your overall rate of return.

I am not a fan of rules of thumb, because they offer an average that may be totally wrong for you. But there is one that makes sense to me: the maximum exposure to the stock market should be 100 minus your age. That means a 30-year-old should have no more than 70% in equities and a 70-year-old should have no more than 30% in the market. Another way to think about it is to have at least your age in fixed income products.

If you stick to this guideline it will automatically reduce your risk exposure as you age because an increasing percentage of your savings will be in fixed income that can’t lose value. It also allows you to have some exposure to the stock market to boost your overall returns. At least that has been the case historically.

Let’s say you are 65 and are retiring this year and that approximately 35% of the equity portion of your portfolio was in the S&P/TSX composite index, or an investment product that mirrored this index, for the past 10 years. How would you have done?

The first thing to note is that the index you see quoted in the media every day is a stock price index. It takes the number of shares outstanding of all the members of the index (approximately 250 at the beginning of 2016), multiplies by the current market price of each stock and divides by the weighted average of all outstanding shares of the members to get a number that is the value of the index. As of the close of business on February 12, 2016, it was 12,381.

The problem is that this index ignores dividends. And that is misleading because if you invest in stocks, whether in individual stocks or through mutual funds or ETFs, not only are you hoping for capital appreciation but also, in many cases, dividends.

The index that includes dividends is called the S&P/TSX composite total return index. If you are trying to analyze how stocks have done in Canada, it’s this you should be looking at.

So how well did the index do over the past decade? Here is a chart of the average annual rate of return for both indexes for one, three, five and 10 years to February 12, 2016.

The first thing you’ll notice is that it’s been a bad year. The second is that dividends make a significant difference, especially for longer periods. That is because about three-quarters of the index members pay dividends.

Remember that indexes are an ideal environment. There are no fees, no taxes and no emotions. An index does not panic when it has just lost almost 20% in the past year, as it has just done.

Let’s assume we are talking about saving in an RRSP. That means taxes are irrelevant, at least during the growth phase.

We’ll also assume that you did not panic during the stock market meltdown of 2008-2009, when both indexes lost almost 50% of their value between June 2008 and March 2009.

But fees are very relevant and unavoidable. Say your investment adviser charges a percentage of assets at a rate of 1% per annum. That means your 10-year average annual rate of return was 2.4% over the past decade. In other words, the equity portion of your portfolio provided a return not much more than you could have received in guaranteed investment certificates.

Usually average equity returns have exceeded GIC returns by at least a few percentage points. Historically it has been the premium you received for accepting the risk of having assets in the market. Therefore your combined average return got a boost from the equity portion.

If you have 10 years to retirement and are entering your key decade, what do these results tell you? Well, if the current trend continues and you stay in the Canadian market, it’ll be difficult to make a 5% average return after fees. That means you’ll have to focus on putting more money away to secure your retirement.

S&P/TSX composite index table. Average annual return to February 12, 2016