One of the core inputs required in the financial planning process is the assumption of what the future return of the security (portfolio) will be. Obviously higher returns are preferable because they translate into greater spending power and/or reaching your goals sooner. Yet higher returns come with a caveat; higher risk. There is a very strong correlation between risk and return. So the higher the desired return, the greater the risk of losing money over a period of time.
It is important that we select an expected return that is also realistic. Just because we expect something, doesn’t mean it is going to happen. And the further our expectation is from reality, the greater the chance of disappointment.
Some investors, when interviewing advisors, select the advisor that uses the highest expected return because the advisor can then show a greater portfolio value over time. But, just being able to type in a greater number on the computer doesn’t have anything to do with whether such a return can actually be achieved. When attempting to achieve higher returns, there is no guarantee…except for the fact that you will be taking greater risk.
It is very important that investors select an expected return that is realistic, and gets updated as your situation and economic situations change. It is natural to be optimistic, and oftentimes investors will choose a bullish expected return – but when it comes to the accuracy of the financial plan, it is more important that the expected return be realistic.
One avenue to identify returns that may be realistic is to take a look at the historical equity risk premium (ERP). The ERP is the additional return over the risk-free rate that investors expect by purchasing risky securities. To find the expected return of a security, we simply add the ERP to the risk free rate. The ERP can vary quite a bit, however several studies have found that the average ERP for stocks has historically been between 4% - 6%.
Ten years ago the risk-free rate, defined here as a six-month T-bill, yielded 5%. Add in the ERP, and a realistic expected return for stocks at that time was 9% - 11%. Today, with the six month T-bill yielding 0.5%, a realistic expected return for stocks would be 4.5% - 6.5%.
This doesn’t mean we won’t get years of double digit growth…perhaps the actual average return will be higher, and we will experience a positive surprise. That is much better than selecting an expected return greater than what history suggests and having to make major life adjustments because the actual return fell short of the expected return.
In financial planning, just like in the stock market, expectations are everything. To a large degree your expectation of future returns is a major contributor to whether you experience positive or negative surprises down the road.
Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.