Monday, August 26, 2013

Risk & Return: Talk About a Complex Relationship!

Imagine you have come to the office of Stoffer Wealth Advisors for a consultation. You need some help in reviewing and structuring your investments. You are concerned about securing a good rate of return on your investments and want to understand what will be the best approach. Here’s how the conversation might go. 

You told us in previous blogpost that “making a big pile of money” was not a good investment goal. If I’m going to invest money, I want a good return. But, what is a good return on my investments? 

Right, investing just to make a lot of money is not really a good objective. It encourages risk taking without adequate consideration of your time horizon (or when you need the money.) An emphasis simply on maximizing returns also does not help to clarify what you are really trying to accomplish. To answer your question we need to take a look at historical returns and risk. 

How do historical returns help us? Don’t we care more about future returns? 
Excellent point! We only look to past returns as a reference for projections about the future. Each asset class, or category of investments, has a history of returns. Data show that stocks have returned about 10 percent per year since the 1920s. We analyze past returns for each category of investment in a portfolio, for example, high yield bonds or emerging markets stocks. Then we evaluate all the factors that may increase or decrease the historical average to arrive at our expectation of future returns.

Can you give me a simple example of an expected return on a portfolio? 
Normally we would diversify among many different types of investments, but for this example let’s consider a portfolio that is 50 percent stocks and 50 percent bonds. If we expect stocks to return 10 percent per year, and bonds to return four percent, then our math is fairly simple. Stocks, which are 50 percent of the portfolio, will yield an expected return of 10 percent. This represents a return of five percent on the stocks in the portfolio (0.5 x 10% = 5%.) The bonds, which make up the other half of the portfolio, are expected to yield a return of four percent. The rate of return, therefore, on the bonds will be three percent (0.5 x 4% = 2%). The total expected return on this portfolio would be seven percent (the sum of the returns of each component of the portfolio, stocks plus bonds.)

As you can imagine the math gets more complicated as we add investment categories. The point, though, is that your range of expected returns may vary from one to two percent (perhaps for an all cash account) all the way up to 15 percent (for an account that is all stocks), but your blended returns will be somewhere along that continuum. Remember, these are just averages and expectations. There are often wild swings around this average. And, we tend to forget this, but long periods of high returns tend to beget cycles of lower returns. In other words, returns tend to revert to their averages. In our current environment of low returns, there is hope for better returns in the future. However, as you know, there are no guarantees.

But seven percent doesn’t sound like much. How can I get higher returns?
Our hypothetical portfolio described above consisted of half stocks and half bonds. To get higher returns, you would need to add riskier investments, especially investments that had expected returns greater than the return on bonds. Remember, as expected returns go up, the risk you take usually goes up as well. 

To be continued...Part II

No comments :

Post a Comment