One thing I’ve noticed over the past few years is that many people have unrealistic expectations about the returns they’ll receive from their investments. In this article we’ll discuss some ideas that affect the return you could receive and we’ll look at what could be realistic returns depending on the type of portfolio you’re invested in.
Why do returns vary?
You may already know about the concept of risk and return and understand how different investments have varying rates of return, usually depending on the level of risk they carry. By combining these different investments (diversifying) you can smooth out your returns – the different sectors will each perform well at different times.
Some investments such as shares and property are expected to perform better over the long term than conservative investments such as cash. In the short term, shares and property will sometimes have poor years, and in those years the cash sector of your portfolio will help to reduce your overall losses.
On average, the more you invest into the growth assets (shares and property), the higher the potential for stronger returns over the long term and therefore it is important for you to understand that negative returns may occur more regularly due to these investments being of higher risk in volatility. If you have more in cash and fixed interest, you will have less fluctuation in returns, but experience lower returns over the long term.
Why does it matter?
When we meet with you, we usually spend some time understanding your goals and objectives. We then look at suitable financial strategies to help you achieve your goals and objectives.
We look at your current financial position and compare that with your desired position in the future. We then calculate whether you’re saving enough to achieve your goals. One of the key factors in these calculations is the expected return.
If the expected return is low, then usually you may need to invest more to achieve your future goals. If the expected returns are high, you can invest a bit less.
Setting realistic returns is very important. If we over-state your expected return we may give you false hope that your goals can be achieved.
We help you decide on the level of risk you’re comfortable in taking, and the asset allocation of your portfolio. We use a range of different portfolios with our clients. Typically, the most popular are classified as Conservative, Moderate and Growth.
The Conservative portfolio has a higher weighting to cash and fixed interest and less in shares and property. This portfolio probably won’t go up and down as much as moderate or growth, but neither will it achieve the long term returns those other portfolios could.
A long term estimate for the Conservative portfolio is 7.3% pa. For the Moderate portfolio its 8.2% and for the Growth portfolio its 8.8%. We have many more Investing Help Articles Now Available.
These are estimated averages only. You may look at them and think that 8.8% doesn’t look very high for a portfolio that’s 80% invested in growth assets. The actual year by year returns could be much higher (or lower). S&P estimates there’s a 90% chance the yearly return for the Growth portfolio could range from -6% pa to +25.1% in any given year. So some years will be good, others bad. Their expectation is that the long term average could be around 8.8%.
It is however, important to remember that past performance is no guarantee of future performance.
Being cautious is best
It is possible that over the long term these portfolios could exceed S&P’s expectations. But they may not. And if you’re planning for your retirement wouldn’t you prefer to base your assumptions on estimates that are cautious in nature rather than using expected returns that may not actually eventuate?
And if you’re retiring now, doesn’t it make more sense to decide on a draw-down rate from your portfolio that gives you confidence your money could last as long as you could?
What really matters?
Here’s a secret that could turn out to be one of the most important bits of financial advice you ever receive.
Ultimately, the expected rate of return is just a number that you’ll probably never achieve.
I can assure you that you’ll probably never exactly receive the expected rate of return. You may average higher, you may average lower, but I doubt you’ll ever achieve that exact rate. And it doesn’t matter.
The expected return is helpful to help you make decisions about how much you need to save for the future to have any chance of achieving your long term goals. It’s a useful starting point.
But the thing that is infinitely more valuable is regularly reviewing your progress towards your plan. You see, your plans will change over time. The date you plan on retiring may change, the amount of income you want in retirement could change, your contributions may change, inflation won’t remain constant and you’ll receive varying rates of return.
By reviewing your progress regularly you’re able to make the little (or big) changes that keep you on track. And by keeping realistic expectations about the levels of return you could achieve you reduce the risk of not having enough money to fund your future lifestyle expenses. We have many more Investing Help Articles Now Available.