Overcoming desire: Setting expectations around returns
July 16, 2013
The following is adapted from a conversation with Vanguard senior investment analyst Don Bennyhoff, one of the authors of a recent Vanguard research paper, Required or desired returns? That is the question. You can listen to a recording of the conversation here.
Let's walk through a few definitions. What is a "required return"?
A required return is the estimate of the return needed to accomplish an investor's objectives, taking into account the client's unique goals, time horizon, current assets, liquidity needs, and so forth.
What's a "desired return"?
A lot of time, the desired return ends up being something that's based on an external influence. It's not based on the individual. It's based on maybe their experience. So it's very common for investors that have even a longer investment experience—say, 20 or 30 years—to be influenced by the returns they've experienced over their own investment career.
What about the media and neighbors and brothers-in-law? Do other things influence a desired return?
I would say that they're probably the greatest influence. The print media, the internet, TV and radio, and the like tend to advertise the best performers, and it sets a very high bar for relative performance. And many people feel like if they're not getting returns like they're hearing about or seeing, that somehow it's not good enough, and that's a real problem because to get those higher returns, most of those investments have to take much, much higher risk, and that may not be acceptable for most investors.
I think it's very important to differentiate that the required return is about the client. It is an output of the financial process that's completely tailored to the unique circumstance of the investor. On the other hand, a desired return comes from something external. It's actually a bias or a return target that's brought to the table that really has very little to do with the client experience.
In the paper, you write, "the way people plan is like buying the building materials for a home before the architect has drawn up the blueprints." What do you mean by that?
Simply, it means that many people buy the investments first without actually thinking about the structure of the investment plan, and putting enough time into the financial planning process. So they buy funds that they've read about that have been top performers and they end up buying a lot of those funds because they have these great recent returns, and that's what we would consider a bottom-up strategy. So they're essentially focusing on the materials for putting together or constructing a portfolio rather than the portfolio structure itself; that would be the blueprint of it. The financial plan serves as that blueprint.
What are some of the benefits of focusing on a required return?
I think, first, it's specifically tailored to the individual and not something more arbitrary, so it is a very good benchmark for success. Are we achieving the returns that we need to achieve our goals?
The other aspect is that because the required return tends to be lower, sometimes significantly lower, than a desired return, it means that you can start with a more conservative asset allocation. By starting with a more conservative allocation and still having a very good chance of achieving your goals, it probably means lower volatility along the way. That's a real important aspect because the volatility that comes with investing can sometimes cause investors to abandon their strategies at the worst time.
So, ironically, using the lower return target of the required returns actually may allow them to create better wealth because they have a longer time in the market. They stay with their investment portfolios better.
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