Realistic Performance Expectations
Most investors develop performance expectations one of three ways:
- They base their expectations on personal knowledge
- They are influenced by the expectations of friends, family, and associates
- Advisors create their expectations during the sales process
Sales Tactic
Our surveys show, more than 75% of the time, performance expectations are created by financial advisors. Naive investors fail to realize these expectations are nothing more than undocumented sales claims. They believe the claims because they want to believe their advisors are ethical financial experts.
However, most advisors are not experts. They are salesmen and they may be unethical salesmen who create high expectations to sell investment products that pay big commissions. Because they are paid in advance they are not around to see if their recommendations actually meet the expectations they created during the sales process.
Some fee advisors also use this sales tactic. They are accountable for meeting expectations, but they have nothing to lose. They may not win relationships if they do not create high expectations. They are paid quarterly fees until investors fire them for failing to meet the expectations that they created. Meanwhile, they collect years of fees until they are fired.
Track Records
Some Wall Street advisors use fake traffic records to create expectations. Some advisors may even have legitimate track records. You can use track records to compare advisors, but records have very little to do with future performance. Otherwise, you could select an advisor who averaged a 20% rate of return for the past five years and expect to earn 20% a year during the next five years. We wish it was that simple.
Risk Tolerance
Performance expectations start with your tolerance for risk. Tolerance measures your willingness to accept losses to earn higher returns. For example, high expectations require a high tolerance for risk. A low tolerance for risk produces low performance. High performance for low risk is a sales scam.
Most investors equate risk to their exposure to common stocks. That is because stocks are more volatile than bonds and most other investments. So investors might have the following allocations to stocks:
- High Risk Tolerance (75% to 100% in stocks)
- Moderate Risk Tolerance (50% in stocks)
- Low Risk Tolerance (0% to 25% in stocks)
Match the Market
Let's assume the S&P 500 produced a 12% rate of return for the past ten years. Is it reasonable to assume it will produce a similar return for the next ten years? The answer is no. It will be higher or lower based on unpredictable economic conditions (GDP growth rate, inflation, interest rates). How can you predict the future when econometric modeling systems with 250 variables can't do it?
Your alternative is to adopt a "match the market" performance expectation. That is, you invest in index funds that are based on the holdings of key market indices (S&P 500). The S&P is up 12% for the year and your assets are up 12%. There may be a slight variation due to investment expenses, but your returns should be within a few basis points. Another important benefit - your risk is limited to the risk associated with being invested in the securities markets.
Beat the Market
Your highest risk strategy is beating the market. You believe the market will be up 15% next year. Your goal is to be up 20%. You win if the market goes up and you outperform it. You lose if the market goes down and you lose more than the market. Meanwhile, you have paid high fees and taken on a substantial amount of incremental risk in your quest to produce superior investment returns.
Additional Criteria
Performance requirements and risk tolerance are the two most important criteria when you develop your expectations. There a few other criteria. Ask yourself the following questions:
- How long is your investment horizon (until you need principal or income)?
- Do you have time to recover from a major financial loss?
- How dependent are you on the invested assets?
- Can you take higher risk and still sleep at night?
Your answers will help you fine-tune your risk tolerance and your performance expectations.
Paladin says.....
The development of a realistic performance expectation is a roll of the dice. No one has a crystal ball that accurately predicts future performance. So what is your solution? Base your decisions on the long-term historical performance of the securities markets. Determine your tolerance for risk. Develop a long-term strategy that will help you achieve your financial goals. Stick with the strategy. Do not attempt to move in and out of markets based on the timing predictions of third parties who are paid to make entertaining predictions.