Before crafting a financial plan, before creating an investment policy statement, before you invest, it’s important to recognize and be familiar with three numbers. These three numbers by themselves will help you make sense of what risk is, what it is not, and what to do about it when you invest your money.
Can you guess what each of these numbers represent? Ten percent is the long-term rate of return on large company stocks. Six percent is the long-term rate of return of bonds. Three percent is the inflation rate, or more commonly known as the rising cost of life. These numbers are updated each year. What these numbers also represent is their long-term historical averages. What may we learn from this when selecting investments and determining how your portfolio should be constructed?
Every portfolio needs to be directed by a plan. A date-specific and duration-specific plan that addresses what role your money serves and the time horizon. Unfortunately, our brains usually seek a shortcut, and this rarely happens. As investors, we’re attracted to past performance and seek-out investments that have already done really well for the short term. Specifically, looking at high current returns or five-star ratings, in order to make a decision may lead you astray. Chasing performance tends to create an ill-balanced portfolio of current great performers. Not all great performers can stay great forever and must underperform at some point. This is how the law of averages works and generates several questions:
- How exactly do you know if your portfolio is doing well when no plan exists?
- What (or how) do you measure the performance of your portfolio?
- How do you even know if your approach is working?
When these questions can’t be answered, the default is to judge the performance of your portfolio against a benchmark. Benchmarks are irrelevant to the patient investor who seeks getting closer to their goals. Judging your portfolio against what your neighbor, co-worker, or family member is getting from a return perspective is equally disastrous. I would hope that your financial professional has shared the value of having a plan for each account so to avoid this common investment mistake. If not, he or she should as it’s the only rational way to go about investing your money. This approach to planning is not common and frankly is counterintuitive when thinking about your goals and how to best achieve them.
A plan will give context around the purpose your money serves. Further, now that your money has a definitive job description, you may go about crafting a portfolio that includes your time horizon.
Now, back to the numbers above.
- What real life returns may you anticipate by looking at the above numbers?
- How will this impact your selection of investments that will be directed by your plan?
What we may learn is that large company values will generate a real-life return after factoring in the rising cost of life. That return is about seven percent, over the long term. We may also determine that investing in bonds will generate a three percent rate of return (roughly) after factoring in the rising cost of life. Which investment do you think stands a higher probability of success when you are managing a 25 or 30 year financial plan? Seven percent or three percent?
Large companies, of course, will generate better real-life returns over a span of decades. The concept is to not invest a single company, or single stock, but rather large, diversified equity portfolios. When you invest money, it’s not only about what you earn, but also what you are able to keep, that impacts your financial plan. If you had the choice of owning companies at seven percent versus lending to companies at three percent, which one would you choose?
Next week, we’ll continue this conversation with the goal of better understanding risk and return.