Recently, I was asked about the return I expect to achieve for clients going forward. I have been asked this question many times in my career and have spent considerable time contemplating how best to address it.
The answer isn’t straightforward, as future returns depend on prices paid today. Overvalued markets return much less than cheap ones and past performance doesn’t tell us much about what to expect tomorrow.
Why are people so focused on the “number”? Humans tend to use a heuristic referred to as “anchoring” in behavioural finance. Anchoring in finance occurs when an investor uses a specific number as a rule to influence their investment decisions. A conservative investor may believe, for example, that stocks have delivered double-digit returns over time and then overweight them in his portfolio. The anchor number persists in his mind even when evidence shows that the perception is incorrect. The investor will be frustrated if his expected returns were not achieved, thinking better management might have solved the issue.
Anchoring can come from past performance, but can also come from benchmarking. Benchmarks such as the S&P500 stock index, the S&P/TSX index or bond indices provide convenient anchors for clients to compare portfolio returns. Unfortunately, the way benchmarks are constructed makes is difficult or impossible to expect to outperform them.
Author and host of StreetTalkLive, Lance Roberts explains the perils of anchoring to benchmarks, “The continual chase to ‘beat the benchmark’ leads individuals to make emotional decisions to buy and sell at the wrong times; jump from one investment strategy to another, or from one advisor to the next.” He goes on to say that “comparison of your performance to an index is the most useless, and potentially dangerous, thing that you can do as an investor.”
“The best approach is to keep fees low and use proven low turnover and ETF strategies to participate in a broad based investment approach that fits with your risk appetite and time horizon.”
Many investors don’t realize that the majority of professional investors underperform their respective indexes even before fees. Mutual Fund companies distort this information by routinely closing underperforming funds or merging them with other, better performing funds.
A better way to deal with the performance issue is as follows:
- First, recognize that you cannot control how your assets perform. Have a thorough financial plan drafted and revisit it periodically to ensure you are on track to meet your goals. Adjust your savings and expectations to ensure you have a high probability of achieving your desired outcome.
- Second, review historical returns for your risk tolerance level. Monte Carlo Simulations provide a review of the range of returns for different portfolios. Make sure you can commit to your portfolio strategy assuming returns match the worst historical return. Be aware that bad markets can persist for long periods of time. Build in a contingency plan.
- Finally, forget about chasing returns or looking for “hot” (and expensive) managers. The best approach is to keep fees low and use proven low turnover and ETF strategies to participate in a broad based investment approach that fits with your risk appetite and time horizon.
These are the steps to a common sense approach that we believe in and one that can keep you invested through good times and bad.
I can’t tell you what your returns will be – but I can listen carefully to your needs, create strategies to help move you towards your goals and be there to support you when the inevitable bumps in the road occur.