Does your Morningstar investment rating say 5 star but your investment returns says 1 star? Singing the investment returns blues. What gives? How can this be?
I recently looked at a client’s portfolio and found a gap between the returns they expected and the returns they actually got. I asked how they developed their returns expectation. The expectation came from reading the previous returns sheet, which suggested a high star rating. This can be called track record investing. This investment strategy focuses on the past. It involves attempts to assess which superior performing investments from the past will continue to be superior in the future in order to invest only in them. (It’s useful to remember that superior investment returns can be identified as superior only after it has occurred.) This is more challenging in a 401(k) or 403(b) plan that has already screened the universe down to a small number from which she could choose.
How much investment returns return do you need?
I hear from 401(k) investors that they hope to make as much as possible or simply to “make money”. These two approaches don’t specifically address the issue of risk. While some hate the word risk, I am unaware of an investment that exceeds inflation that does not have risk. Even insurance companies that sometimes say a guaranteed return have a disclaimer saying subject to the claims paying ability of the firm. Yes, insurance companies do go out of business.
Why not start with the question of how much return do you need? That starts with some level of planning. Questions that should be answered:
- What is the goal?
- When do I want to reach the goal?
- How much can I save?
- This approach limits the need of taking on excessive risk. Why take on risk where there is no need?
- How much risk do need to take
Yes, I said it. Risk. There are many forms of risk. The risk of a bad advisor, a bad investment, a bad market, a bad sequence of returns, the risk that rising prices outpace the growth in your account, the risk of targeting too little or too much return.
Often in investing you are given a benchmark. The popular benchmark is the S & P 500. Often US investors use the S & P 500, a measure of the returns of the top 500 US companies. This is one way for an investor to determine if the investments they chose to sink their money into is performing well. While you can simply choose to invest in all 500, many invest advisors say they can do better. Tracking error is a way of determining if they matched their bravado.
While often quoted it is often misused. For example, if you have investments such as bonds in your portfolio, it would be wise to compare your returns to a comparable percentage of bonds. You may use the MSCI Bond Index or Government Bond Index depending on the returns you want to track. We’ll discuss that in a future blog.
Investment returns, better recipes or better ingredients
Some investors choose to focus on fine-tuning the recipe. That is the approach I use. A friend of mine’s mom owned a restaurant. My parents said it was the best Italian food that they ever had. One day they let me go into the kitchen. I was shocked to find out that they were not using the finest ingredients. Their focus was on great food at a reasonable price. Apparently, paying more for ingredients to use in Grandma’s recipe was not their ticket.
Frequently there are recipes on the boxes of the ingredients that you buy. Most of the ingredients call for generics, like salt or sugar. However, the manufacturer of the brand you selected specifies you use their brand for that needed ingredient. What if you used the generic rather than name brand? Would it change the taste?
In fact, what if you saw food as science? Getting the purest form of one ingredient to pair with the purest form of another ingredient scientifically works. Oil and vinegar, in the right proportions, stirred vigorously, blend together. You might improve on that by adding a few ingredients. Scientifically vinegar is an acid. You could use another acid, like lemon or lime. You may try this substitution to alter the flavor or to save money.
Getting yourself recharged
I think that starts with having a plan to reach your goal that stipulates the investment return that you need. As investments that carry risk have variability, you should seek the variability or the rollercoaster that best suits you. That may mean taking on more risk because you can’t save more or wait longer or taking less risk because you don’t want risk your principal when there is no need to do so. Finding a pattern of returns consistent with not feeling on edge will go a long way to letting time and markets do their thing. Besides you should focus on what you can control- saving and time (God willing). If you want to learn about an approach based on 90 years+ of financial science, let us know. Much of it can be found in textbooks and Google if you know the right search terms. Done learning and want to get a portfolio risk analysis? Take our Free Portfolio Risk Analysis.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.