I want 18% returns – is this achievable?
The biggest communication gap between advisors and investors is in fully explaining how much risk you need to take to achieve specific returns.
Everyone wants the best returns the market can offer, but how much risk do you have to accept to achieve those return goals?
When I started my career building funds and later expanded to also advise investors on portfolio structuring, retirement planning and investment management, I realized that very often investors have unfair expectations of their investment advisors through no fault of their own… THROUGHOUT THEIR FAULT.
This is simply because returns of all kinds can be generated, and this is told to the investor, but what is not fully explained is the risk that capital is exposed to generate these returns. I came across a chart that I honestly think explains this relationship between risk and reward in the most profound way possible.
If this chart is understood correctly, return expectations will be transformed in the world of investing.
This graph explains two factors:
- To achieve average returns of a specific percentage in a portfolio, how much loss will an investor need to be able to absorb in poor market conditions to achieve the return goal in mind.
- What a significant difference does “time on market” make to an investment that takes some risk.
How to read this graph:
- As seen at the top left of the chart, the orange line indicates that this portfolio is invested in pure stocks.
- For this example, I will explain how to achieve the highest return profile on this graph (the orange horizontal line) which is between 18% and 20% average returns (shown on the Y axis).
- Focus on the black dot on the orange line. This point works with the X axis which shows the “lowest return”.
- As the chart indicates, the black dot indicates “1-year” returns.
- In other words, the black dot on the orange line indicates that the lowest measured one-year return in this portfolio was around -48%.
This means that as an investor who wants an advisor to achieve average returns of between 18% and 20%, the investor will have to deal with the fact that there is a possibility that the portfolio could drop 48% in one year (in terrible market conditions) .
Now, this is where things get interesting. Let’s look at the blue dot on the orange line. The blue dot represents the lowest five-year return this portfolio has measured from 1960 to present.
Note that this portfolio still had the potential to average 18% to 20%, and the blue dot indicates that the lowest return this portfolio had produced over a five-year period was 1%.
This means that if invested in pure stocks, it had the potential to achieve average returns of 18% to 20%, but even if invested in the worst possible market conditions, the investor would not has not recognized a capital loss over a period of five years. period.
If we look at the orange dot on the orange line, it shows that the average returns are still 18%, but the lowest return was around 5%.
So, just to take it back to the beginning and explain this in layman’s terms:
- If you want 18% returns but cannot afford a 48% drawdown over a one-year period, the advisor cannot be expected to achieve those returns.
- Investors who want a potential return of 18% and who know they can leave the investment for five years are confident that there will be no capital loss in the portfolio.
The most important aspect illustrated by this graph is that the longer investors remain invested, the less risk there is of capital loss. A high-risk investment with great potential for return cannot be measured over a one-year period.
So yes, an advisor can get all the returns investors want in a portfolio, but the higher the return expectations, the more time the advisor will need and the more comfortable the investor will have to be with very poor performance for some years.