What should I expect from my investment returns? A very simple question, but one that has a very complicated answer. In order to earn a return on investments that exceeds inflation, an investor must take some risk. By taking risk to increase possible future returns, the investor is also taking on return variability. See our blog Preserving Wealth During Market Volatility.
Return variability almost ensures that an investor will never really earn their expected return at any given measurement period. Investors should consider a range of returns instead of one specific target.
If investors must consider variability in investment returns, what should an investor use to signal whether they are on target to meet long term goals? Some investors believe that a 3-year or 5-year annualized return should be representative of expected returns.
In reality, while the average of these annualized returns should be reflective of the expected return over a long period of time, this is not so during any one specific measurement period.
For example, an investor in the below 60% stock/40% bond portfolio would probably conclude that 6% is a good indicator of what the 3-year annualized return might be over time. Unfortunately, because of the volatility of returns, the 3-year annualized return at any specific measurement period would not have been a good representation of the longer-term performance of the portfolio.
In the graph above, 60% stock/40% bond portfolio’s average 3-year annualized return over the last 20 years is over 6.5%. However, the 3-year annualized return at any specific year over this period would not have been helpful in evaluating longer term performance. It would have shown that in 2009, the 3-year annualized return was 0% and just a year later, the 3-year annualized return was close to 5%. That’s almost a 5% swing in 3-year annualized performance in just a year!
At each of these measurement points, investors would have still been on track to earn their 6% goal, but it would not have looked that way at the time of these performance measurements.
Because of this variability, investors must place ranges around expected returns instead of just a specific single number target.
For instance, in the 60/40 portfolio above, the expected return over an entire business cycle is 6%, with any given 3-year normal expected annualized return number between -4% and +14%. Whether this investment portfolio above is reflecting a -4% return or a +14% return, both would be within a normal expected range to produce a 6% return over an investors long term investment horizon.
Although there are many ways to measure returns, investors should understand that there is volatility in all measurements. Volatility must be considered when discussing whether an investor is on track to meet their goals. Because of this variability, investors should look at the bigger picture – Can my financial plan withstand varying expected returns?
At FAI Wealth Management we believe investment management and financial planning must work in tandem. Working with a financial advisor can help “stress test” your financial plan, helping you adjust to increase your probability of success with variable portfolio returns.
Keep your longer-term return goal and financial plan in mind when reviewing investment returns. A range of returns at any given period can still signify your ability to meet your goals.
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