Markets & Economy
Overcoming desire: Setting expectations around returns
July 11, 2013 | Don Bennyhoff, senior investment analyst
Casey Aspin: Hello. Welcome to Vanguard's Investment Commentary podcast series. I'm Casey Aspin. In this month's episode, which we're taping on May 21, 2013, we're going to discuss a recent Vanguard research paper that helps investors distinguish between the return they desire and the return they actually require to meet their goals. I'm here with one of the paper's authors, Don Bennyhoff, a Senior Investment Analyst in Vanguard's Investment Strategy Group. Welcome, Don.
Don Bennyhoff: Thanks, Casey.
Casey Aspin: Don, let's walk through a few definitions. What is a required return?
Don Bennyhoff: 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.
Casey Aspin: So what is a desired return?
Don Bennyhoff: 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 investing experience—say, 20 or 30 years—to be influenced by the returns they've experienced over their own investment career.
Casey Aspin: What about the media and neighbors and brothers-in-law? Do other things influence a desired return?
Don Bennyhoff: 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.
Casey Aspin: So I know a lot of advisors will be listening to this podcast and they face the client coming through the door, they've seen the advertisements for the great funds, and they have a desired return that may be out there. So what should an advisor say to a client to help them accept the required return approach rather than the desired return approach?
Don Bennyhoff: Well, I think it is a very, very common problem because many of the clients are trying to judge the performance of the portfolio and the advisors themselves. It's their rough standard for trying to determine success. For advisors, 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.
Casey Aspin: There's a great quote in the paper that I'd like to read. You say, “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?
Don Bennyhoff: 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 'cause 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.
Casey Aspin: So what are some of the benefits of focusing on a required return?
Don Bennyhoff: 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 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.
Casey Aspin: I think given the level of uncertainty in the markets today, that's very good news for the conversation advisors are having with their clients. So thank you for all of this information and thank you for coming in today.
Don Bennyhoff: Thank you, Casey.
Casey Aspin: We hope you've enjoyed this Vanguard investment commentary podcast. Please be sure to check back with us each month for insights on the markets and investing. Thanks for listening.
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An episode from Vanguard's Investment Commentary podcast series
Many investors have an expectation around a desired return, a figure that may be based on recent history, the media, or other external factors. In this podcast, we discuss the difference between this externally driven return and a required return—a return that is tailored to the investor and is based on the investor’s unique situation.
Note: All investing is subject to risks, including possible loss of principal.