Risk, Expected Returns & Investor Behavior...
There has always been a discussion of risk when financial advisors talk to clients about investing, but what about expected returns? Not the kind of expected return thrown out by the advisor who is trying to entice clients with juicy (albeit probably unreal) returns. Or the casual reference to long-term averages without qualification of the often-significant period-to-period deviation from the average? In 2019, Schroders* instituted a global survey of 25,000 investors. Their findings are striking…and speak to many of the issues we raised in our June 2022 newsletter.
Here are the highlights of Schroder’s findings (their findings in quotes, our narrative follows):
“The average holding period before changing or cashing in an investment is 2.6 years, which is just over half the five-year term experts generally recommend to stay invested for.” In his original investment partnership, Buffet forewarned potential investors they had to be committed to a minimum of five years and the ability to risk up to 50% of their investment, or find another manager. I am sure those investors who passed on their chance have considerable regret. One of our greatest fears as advisors is we are correct in our guidance to investors, but the outcomes take so long to be realized, investors force a premature change. As noted in our newsletter of October 2022, if history repeats, and there is no guaranty it will, at some point the Fed begins to lower interest rates which has historically been positive for both stocks and bonds.
“Investors expect on average a very high 10.7% return per year over the next five years, while one in six expect at least a staggering 20% annual return on their total investment portfolio.” When markets are strong, clients tend to gravitate to a higher risk tolerance, and lower when markets are in decline. This is a normal investor behavior, and can have negative consequences to their portfolios if acted upon without a robust conversation and review of goals, current and historic markets and economic data.
We use multiple asset allocation tools that rely on historic returns to extrapolate potential portfolio volatility (a measure of risk) and return. However, these tools rely on historic data that is collected over decades…and these periods typically exceed the lifetime, and certainly the retirement period of, most people’s lives. For example, the lost decade of the 2000s which saw the S&P 500 offer investors negative total returns from 2000-2009 while the market got cut in half not once, but twice. Our role as advisors, in tandem with our asset allocation and risk tolerance tools, is to help frame for clients risk and return expectations.
Why the necessity for a robust conversation? Well, you can elect to have more certainty about expected returns with an asset class like bonds, but face credit, interest rate and inflation risk (to name a few…). Or, a lower level of expected return certainty comes with investing in an asset class like domestic small cap stocks, but that lower level of certainty has accompanied higher volatility and historically, but not guaranteed, one of the higher performing asset classes available to investors. The mix, that mix that integrates the investor’s goals, risk tolerance, risk capacity, and return expectations is so unique to each investor, it necessitates a robust conversation to help clients understand that markets are a complex place, and nobody has a perfect understanding, but research, understanding of asset classes and investment vehicles, coupled with asset allocation tools provide an improved - but not perfect - opportunity for investors. Sincerely, Dave & Drew *Schroders plc is a British multinational asset management company, founded in 1804.