When I think about investment returns, I also wonder why we always chase returns we want, versus accepting returns we need to meet our goals. For ourselves and relative to our peers, we’re always looking to do better, achieve more, or climb higher. In order to get there, we’re taking on more risk, or having more ups and downs. This fallacy can take us off course in meeting our goals by subjecting us to greater volatility than we perhaps can withstand.
My young daughter was recently at the playground with other children of various ages. As she climbed the monkey bars and started going across, she had already accomplished what kids her age were doing. But then she sought to replicate the older children by climbing on top of the bars, a feat that I was watching from below and not at all comfortable with. It made me stop to consider why we strive for more and are not content with a reasonable result for an appropriate level of risk.
Where do our preferences for desired returns come from: a trend heard in the media, a tidbit from an acquaintance, or extrapolating historical returns to future return expectations? There can be great disconnect between the returns we want and the returns we actually need to meet our goals. I recall a conversation with a client who stated up front that he was looking for an 8% return from his portfolio each year. After discussing his goals, how much longer he planned to work, his lifestyle, and spending habits, we determined that he only needed a 4% average annual return. We also found that he really wasn’t prepared for the market swings that can accompany an asset mix that averages 8% per year. In investing, when we seek higher returns, proportionately higher risk is a result.
However, risk is never discussed in a conversation with a friend, peer, or acquaintance about investment returns. We tend to focus on the result and not the effort or volatility to get there. When the client I mentioned previously learned that the worst year’s return for a portfolio with an average return of 8% was a negative 20%, he quickly realized that the risk for him was not appropriate. When we concluded that he could meet his needs with an average annual return of 4%, he was more willing to tolerate a loss of 8% as seen in worst years historically. This page shows examples of the historical range of returns associated with various portfolio allocations and varying levels of risk.
We should re-frame our expectations for returns we need, versus returns we want. Consider first your goals, cash needs, time horizon, and starting net worth.
Ask yourself: How much return do I need to meet my objectives? What risk is associated with an asset allocation that produces the return I need? Can I accept the volatility of such an asset mix? Remember that your asset allocation decision will largely drive your long-term returns and is the key to meeting your financial goals.
So, why should you consider taking more risk than you need for potentially greater returns than you need? Sure, we all want more, but when it comes to returns, consider the flip side. There is no free lunch, and chances are if an investment can pay off big, there’s much more at stake. Focus instead on the returns you need, and you will sleep better at night. With a disciplined financial plan, you’ll also have a better chance of investment success!
All investing is subject to risk, including the possible loss of the money you invest.
Advice services are provided by Vanguard Advisers, Inc., a registered investment advisor.