One of the first things I do when I meet with a new client is have a conversation about their return expectations. It’s an exceptionally important topic, one that sets the tone for the entire relationship.
Some clients have wildly unrealistic expectations about returns. They’re looking for 10%, 25%, 33%, 50% or greater returns from their portfolio year in, year out. Other clients haven’t thought about returns at all. They talk about things like security, safety, passing on wealth to children, etc.
The most interesting, however, are the people who come in with specific return expectations, but those expectations are out of sync with their goals. In other words, their desired returns and their required returns don’t line up.
I recently read an interesting paper from the Vanguard Investment Strategy Group on this topic, written by Don Bennyhoff and Colleen Jaconetti. As the authors point out, the disparity between desired returns and required returns can often have very serious consequences.
Sometimes desired returns are lower than required returns. This tends to happen with investors who are acutely concerned about risk, afraid of volatility and nervous about public markets. They don’t really think about their investments in terms of desiring lower returns, but that’s what their penchant for cash, GICs and ultra-low-risk bonds really comes down to.
For some people, it’s the opposite: their desired returns are actually higher than required returns, often because of external influences. It could be investment news and/or headlines. It could be “best of” lists or “20 stocks to own now” articles that create the desire. Sometimes it’s the influence of friends and family – a desire to “keep up with the Joneses.” Or maybe a desire to “beat the market.” I remember at least a handful of cases in which it’s simply been an arbitrary number that the client felt he wanted to achieve.
In these situations, desired returns end up driving portfolio goals. The portfolio is built around achieving a number, rather than achieving specific lifestyle or financial goals (a target annual income, creating trusts for children and grandchildren, establishing a charitable foundation, etc.).
Obviously, this is exactly the opposite of how wealth management should be done. When you have to stretch for some artificial return goal, your portfolio allocation can end up overweighted toward higher-risk assets.
It can also mean a lot more volatility, which can play havoc with financial planning and necessitate a lot of adjustment and recalculation when ideas don’t work out as planned.
Finally, because higher-risk assets are inherently more volatile, it can also bring an element of added emotion into the wealth-management process and make the investor vulnerable to erratic asset juggling. When return expectations aren’t met, the investor feels the need to jump into and out of certain investments just to feel as if progress were being made.
The irony of this is that it’s often unnecessary. Often the best thing we can do for ourselves is to seek lower returns. Sure, we all want higher returns – including me! But when we understand the difference between what we want and what we need (especially after tax/inflation), interesting things start to happen.
We start making more rational decisions, and we stick to them. We evaluate our success differently. We tend to have more confidence in our long-term financial plan. We’re less easily shaken by market events.
The next time you think about the returns from your portfolio, I encourage you to ask yourself: is this the return I want? Or the return I need? You might be surprised at how much clearer your financial decisions become.
