Expected Returns: Finding the Right Balance Between Risk and RewardSubmitted by Miller Premier Investment Planning, LLC on September 16th, 2016
One of the core inputs required in the financial planning process is the assumption of what the future return of a given portfolio will be. Obviously higher returns are preferable because they translate into greater spending power and/or reaching your goals sooner. Yet higher returns come with a caveat; higher risk. There is a very strong correlation between risk and return. So the higher the desired return, the greater the risk of losing money over a period of time.
It is important that we select an expected return that is also realistic. Just because we expect something, doesn’t mean it is going to happen. And the further our expectation is from reality, the greater the chance of disappointment.
Some investors, when interviewing advisors/brokers/insurance sales folks, select the financial/sales professional that uses the highest expected return because the advisor can then show a greater portfolio value over time. But, just being able to type in a greater number on the computer doesn’t have anything to do with whether such a return can actually be achieved. When attempting to achieve higher returns, there is no guarantee…except for the fact that you will be taking greater risk. If anyone tells you different.... run -- don't walk the other way!
Therefore, it is extremely important that investors select an expected return versus risk balance that is realistic, and gets updated as your situation and economic situations change. It is natural to be optimistic, and oftentimes investors will choose a bullish expected return – but when it comes to the accuracy of the financial plan, it is more important that the expected return be realistic. This can be accomplished by running bad timing scenarios against plan goals where the worst returns (usually negative) happen at the worst possible moment in a return sequence or how returns fall from one year to the next over time. The plan should also be battle tested when it comes to returns using real life historical returns in good markets, average markets, and the worst of markets. The best risk versus reward balance is the portfolio that gives you the highest probability of reaching your goals thru all market environments.
One important thing to point out about current expected returns versus historical returns is a factor called the historical equity risk premium (ERP). The ERP is the additional return over the risk-free rate that investors expect by purchasing risky securities. To find the expected return of a security, we simply add the ERP to the risk free rate. The ERP can vary quite a bit over time, however several studies have found that the average ERP for stocks has historically been between 4% - 6%.
Ten years ago the risk-free rate, defined here as a six-month T-bill, yielded 5%. Add in the ERP, and a realistic expected return for stocks at that time was 9% - 11%. Today, with the six month T-bill yielding 0.5%, a realistic expected return for stocks would be 4.5% - 6.5%.
This doesn’t mean we won’t get years of double digit growth…perhaps the actual average return will be higher, and we will experience a positive surprise. That is much better than selecting an expected return greater than what history suggests and having to make major life adjustments because the actual return fell short of the expected return. These adjustments usually come with some pain such as working longer or living on less. After the high flying 90s it was very common to see newspaper and magazine articles of couples having to come out of retirement and go back to work because they had used high expected returns (some over 20%!) Why you might ask would they use such a high return assumption? Because that is what tech stocks were earning in the 90s. Unfortunately, that party didn't last and a valuable lesson was learned. Make sure your plan is battle tested for all market environments.
In financial planning, just like in the stock market, expectations are everything. To a large degree your expectation of future returns is a major contributor to whether you experience positive or negative surprises down the road. I hope you found this helpful and more importantly that you take action on it! I pray the best of blessings for you and those you love and that you achieve maximum return on life!