When asked about their return objectives, most investors are quick with an answer—to earn as much as possible. However, when pressed, few can articulate the actual investment return required to turn these longer-term objectives into reality. Part two of our five-part series on identifying and working to resolve some of the most prevalent investment portfolio mistakes focuses on how setting the wrong return expectations can both increase your risk and render your objectives unattainable. Today, we will discuss how to establish realistic objectives and, as importantly, stay on track towards those objectives.
Risk and return: Understanding the relationship
For a wealth accumulation strategy to be successful, two levels of contributions are required. You contribute capital to the effort by foregoing current spending and, instead, saving money for the future. Your portfolio contributes to the effort through the return it achieves. All factors being equal, the more investment return you achieve, the less you would have to save towards your objective. To achieve more return, you have to be willing to assume more risk. However, as we discussed in part one of this series, simply taking more risk does not guarantee that more return will follow. In fact, taking more risk at the wrong time or with the wrong strategy could have the opposite effect and require additional savings to make up for losses. Therefore, finding the right balance between risk and return is essential.
Then and now: Setting realistic expectations
Most investors feel that stock returns should approximate their historical 10 percent average since 1928. Those that build portfolios based on this assumption are more than likely going to be disappointed by the results they actually achieve. If you consider the expected return on an asset class such as equities is more or less a sum of its parts, it becomes easier to understand why history may not repeat itself for the foreseeable future. Consider the example below:
Expected Equity Returns =
|Expected Inflation Rate +||Expected Real Earnings Growth Rate +||Expected Dividend Yield||= Expected Equity Returns|
While this is admittedly a simplified example, you get the picture. To achieve the historical average of 10 percent, something unexpected would have to happen. While a possibility, it is not a high enough probability to bet your future on.
Your objective for your portfolio should be the rate of return, above inflation, you will need to reach your wealth goals. The higher your return requirement, the higher your risk of falling short, therefore, if your return requirement is too high, you may want to consider adjusting your objectives, your savings rate, or both. In today’s market, any return objective over 6.5 percent (inflation plus 4.25 percent) should be reevaluated.
Managing your portfolio efficiently and objectively
Once you understand your return requirement, achieving that objective with the minimal risk possible should be your singular objective. Often, however, the competing emotions of greed and fear take hold of an investment strategy.
During strong investment markets, investors lose sight of their long-term goals and focus, instead, on how their return is comparing to the market indices and other investors. In these markets, their return requirement seems inconsequentially small compared to the market returns then prevailing. The siren’s song of higher returns often proves difficult to resist and results in a complete or partial abandonment of the long-term strategy. However, higher returns sans a change in underlying market fundamentals prove fleeting and unsustainable. Remember, there is no free lunch. By the time investors recognize this, it is too late and they are in the throes of a bear market. Watching losses mount, they again lose sight of their long-term objectives and slash the risk to stem the losses. Fear has won. At this reduced risk level, their portfolio is no longer capable of generating the return needed to achieving their long-term objective. Again, market forces have conspired to undermine what is truly important.
The bottom line
Given the current level of the markets, today may be an opportune time to reevaluate what you are trying to accomplish to ensure your portfolio is positioned to meet those objectives. Prudent investing is about building an investment strategy that satisfies your return requirement and is consistent with your tolerance for risk.
If you still have questions about risk, overestimating returns and designing and maintaining a portfolio that efficiently manages these circumstances, we encourage you to reach out to our team of private wealth advisors. We will also be sharing three more of the most common portfolio mistakes so keep an eye out for on our blog—stay tuned for our upcoming updates.
Common Mistakes Investors Make in Their Portfolios:
- Are You Properly Defining and Managing Risk in Your Portfolio?
- Setting Realistic Objectives: How Overestimating Your Portfolio’s Return Potential Can Increase Your Risk and Hurt Your Chances For Success.
- Are You Letting Emotions and Overconfidence Alter Your Investment Strategy?
- Paying Too Much in Taxes? Two Ways to Manage Taxes in Your Portfolio
- Making Time Work for You in Your Investment Portfolio