Your investment plan offers a blueprint for financial success. But how do you measure success? Too often we compare the performance of our portfolios with a mix of reference points, such as the S&P 500 Index. We may think: The S&P 500 was up 10% last year, so why was my portfolio only up 6%? The S&P 500 may seem like a reasonable performance benchmark. After all, it’s the most widely discussed proxy for U.S. stocks and stock market returns.¹ While this index is a standard benchmark for returns, it’s typically not the right benchmark for investors whose portfolios tend to be fairly diversified between stocks and bonds.
Desired return: The siren song of success
A desired return is an objective or benchmark based on external factors or influences rather than factors or influences specific to your personal circumstances. The simplicity of using a desired return to measure your investment success is alluring, but its applicability to your unique portfolio is deceiving. Looking at S&P 500 Index returns is an example of a desired return. From 1926 to 2016, the average annual return for U.S. stocks was a little more than 10%, a statistic that seems like common knowledge to most of us.² So a 10% return is a reasonable expectation for an average year, right? Our illustration below shows how often that assumption is mistaken.
Returns are almost never average
Annual stock and bond returns, 1926–2016
Notes: Represents each calendar year from 1926 to 2016 (91 points = 91 years) plotted at the intersection of that year’s stock return and that year’s bond return. The vertical shaded area contains all years whose stock return was between 8% and 12%. The horizontal shaded area contains all years whose bond return was between 3% and 7%. Stock returns are represented by the Standard & Poor’s 90 Index from 1926 through March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Dow Jones Wilshire 5000 Index from 1975 through April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Bond returns are represented by the S&P High Grade Corporate Index from 1926 to 1968, the Citigroup High Grade Index from 1969 to 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 to 1975, the Bloomberg Barclays U.S. Aggregate Bond Index from 1976 to 2009, and the Bloomberg Barclays U.S. Aggregate Float Adjusted Index thereafter.
Required return: A better benchmark for success
Your compass for progress should be your required return, which is an output of your financial plan. Your required return is based on your financial needs and aspirations, risk tolerance and tax circumstances, current and expected assets and liabilities, and expected capital contributions or savings. Your required return is essentially the average return necessary to meet your most important objectives. It’s a vital part of developing an asset allocation that balances your risk tolerance and return objectives. (And for most of us, our required return is often far more modest than a 9% or 10% desired return, which is good news, since most of us would probably have a hard time enduring the volatility of an all-stock portfolio.)
Investment progress is personal
Your required return is based solely on your personal investment plan, which, in turn, is based on your unique situation and circumstances. Your required return drives your asset allocation decision, helping you build a balanced portfolio that can appropriately moderate both risk and volatility.
A desired return, on the other hand, is impersonal at best. It’s based on external factors, such as day-to-day market performance and the news. Using a desired return, such as the S&P 500, as your compass for success will likely steer you into troubled waters. Most investors have portfolios more balanced between stocks and bonds, so a performance comparison with an all-stock index is bound to disappoint.
A required return—not a desired return—is your “mile marker” en route to achieving your personal goals. Keeping your eye on the horizon (and your focus on your required return) can keep you motivated to stick with your long-term plan. It’s a realistic performance measure because it’s based on real life—your real life.
1 In our view, a more complete representation of the U.S. publicly traded stock market would be an index such as the CRSP US Total Market Index, which included nearly 3,600 companies as of June 30, 2017.
2 When determining which index to use and for what period, we selected the index we deemed a fair representation of the characteristics of the referenced market, given the information currently available. For U.S. stock market returns, we used the S&P 90 Index from 1926 through March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Dow Jones Wilshire 5000 Index from 1975 through April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter.
- All investing is subject to risk, including the possible loss of the money you invest.
- There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- Diversification does not ensure a profit or protect against a loss.