People often have unrealistic expectations when it comes to investment returns. After all, what is a good return on investment? Risk plays a part, but how much risk do we have to take to earn good returns? Imagine you have come to my office for this conversation. Here’s how it might go.
You told us in a prior blogpost that “making a big pile of money” was not a good investment goal. If I’m going to invest money, I want a good return. But, what is a good return on my investments?
Right, investing just to make a lot of money is not really a good objective. It encourages risk taking without adequate consideration of your time horizon (or when you need the money.) An emphasis simply on maximizing returns also does not help to clarify what you are really trying to accomplish. To answer your question we need to take a look at historical returns and risk.
How do historical returns help us? Don’t we care more about future returns?
Excellent point! We only look to past returns as a reference for projections about the future. Each asset class, or category of investments, has a history of returns. Data show that stocks have returned about 10 percent per year since the 1920s. We analyze past returns for each category of investment in a portfolio, for example, high yield bonds or emerging markets stocks. Then we evaluate all the factors that may increase or decrease the historical average to arrive at our expectation of future returns.
Can you give me a simple example of an expected return on a portfolio?
Normally we would diversify among many different types of investments, but for this example let’s consider a portfolio that is 50 percent stocks and 50 percent bonds. If we expect stocks to return 10 percent per year, and bonds to return four percent, then our math is fairly simple. Stocks, which are 50 percent of the portfolio, will yield an expected return of 10 percent. This represents a return of five percent on the stocks in the portfolio (0.5 x 10% = 5%.) The bonds, which make up the other half of the portfolio, are expected to yield a return of four percent. The rate of return, therefore, on the bonds will be three percent (0.5 x 4% = 2%). The total expected return on this portfolio would be seven percent (the sum of the returns of each component of the portfolio, stocks plus bonds.)
As you can imagine the math gets more complicated as we add investment categories. The point, though, is that your range of expected returns may vary from one to two percent (perhaps for an all cash account) all the way up to 15 percent (for an account that is all stocks), but your blended returns will be somewhere along that continuum. Remember, these are just averages and expectations. There are often wild swings around this average. And, we tend to forget this, but long periods of high returns tend to beget cycles of lower returns. In other words, returns tend to revert to their averages. However, as you know, there are no guarantees.
But seven percent doesn’t sound like much. How can I get higher investment returns?
Our hypothetical portfolio described above consisted of half stocks and half bonds. To get higher returns, you would need to add riskier investments, especially investments that had expected returns greater than the return on bonds. Remember, as expected returns go up, the risk you take usually goes up as well.
I’d like my portfolio to earn about 15 percent per year for the next ten years until I retire. Does that sound reasonable?
My first response is that it is an unrealistic expectation. A portfolio constructed to earn such a high level of return would have to be in the most risky investments. You would have to be prepared to stomach wild swings in the value of your portfolio. Even though the expected returns are higher, you could end up losing money, if you were forced to sell at an inopportune time. If you anticipate that a return of 15 percent a year would allow you to reach your target portfolio of $1,000,000, due to the high level of risk, you could end up with just $600,000, a far cry from your goal. Risk plays a key role in returns and is something each investor needs to factor into his or her plans.
So, if I don’t want to take more risk, what does this mean for retirement planning?
If you are like many people, you want to make steady progress toward your goals. It may take longer to reach them, but you prefer a less risky approach. You have worked hard to accumulate your assets and therefore you place a great value on preserving them. This assessment suggests it will be appropriate for you to begin saving and investing early on to allow time for your investments to compound.
Added savings each year can make a big difference. Let’s say your portfolio grows 10 percent in a year you also added 10 percent in savings; your portfolio increases 20 percent in value.
Finally, your age and time horizon are very important factors in understanding the equation of your expected returns. As you get closer to retirement, you have accumulated some assets. It is inadvisable to continue taking as much risk as you may have taken in earlier years. The pain of potential losses and the possibility of falling well short of your goals pose a level of risk that is just too great.
After I’ve retired I will no longer be saving. And I should be more conservative. So I might have an expected return of only five to six percent?
That’s right. Which makes it all the more imperative to have an investment mix that suits your capacity for risk while meeting your spending needs. You want to feel confident that you can stick to your plan, because getting nervous and bailing out of your risky investments during a market downturn usually results in poor returns. Also consider that you want an investment mix that minimizes the chance that you run out of money. You can see now that risk and return go hand in hand.
Yes, thank you.
Thank you for asking good questions!
This article is for educational purposes only. It is not intended to be specific investment advice.