Performance is Key
All investors want to maximize their asset amounts to pay for current lifestyles, comfortable retirement years, and financial security late in life. There are two ways to accumulate these assets: savings and investment returns. After a critical mass of assets is achieved the more important one is performance. Consider this example, to see the difference:
- You earn $150,000 per year and have a 10%, after-tax savings rate ($10,000)
- You earn 10% on your $500,000 of retirement savings account ($50,000)
There are also two critical variables that impact your future asset amounts: The rate of return that you earn on your assets and the amount of time you can compound returns before you need income or begin spending principal. The higher the return and the longer the time period the more assets you will have for your future use. For example, you start with $100,000:
- You have a constant return of 10% over various time periods:
- You'll have $259,374 in ten years
- You'll have $672,750 in twenty years
- You'll have $1,745,000 in thirty years
- You have a constant time period of 20 years and your rates of return vary:
- At 6% you'll have $320,714
- At 9% you'll have $560,441
- At 12% you'll have $964,629
You are observing two financial phenomenons: The power of compounding and the impact of higher returns. In the first example the time element went up three times, from ten to thirty years, but the asset amount went up more than six times. In the second example, the return doubled from 6% yo 12%, but the asset amount tripled. In the second example, the increased asset amounts due to the 9% and 12% returns reflect the impact of higher reinvestment rates.
The Dual Impact of Bad Results
Bad results don't just reduce your rate of return. They also reduce the number of years you have for compounding higher returns. For example, you earned 10% in a year when the market was up 20%. Not only did you lose the difference between your return and the market return, you also lost the year. Both are irretrievable and all of your future results are impacted by reduced asset amounts. Consider this example for $500,000 of assets:
- A 10% return increased your asset base to $550,000
- A 20% return increased your asset based to $600,000
If bad results persist long enough you will undermine your financial future.
Bad Results can be Hidden
More than 50% of investors are experiencing mediocre or bad results, but they don't know it. That's because the advisor who is responsible for producing the results also controls the information that you rely on to evaluate the results. Advisors have a major conflict of interest because accurate information about their results could get them fired. Instead, they know how to:
- Make bad results sound acceptable - for example, report gross returns and not net returns
- Divert responsibility for bad results away from themselves - for example, blame the market for the results
Risk & Reward
Your returns will vary based on what you have told your advisor, in particular your rate of return expectations and your tolerance for risk. For example, two investors gave these instructions to their advisors:
- Investor A told his advisor he has a high tolerance for risk and the performance goal is to beat the S&P 500 by 4%
- Investor B told his advisor he has a low tolerance for risk and his performance goal is to average an 8% return
Investor A has a higher risk, relative performance goal and investor B has a lower risk absolute goal. The question you should be asking yourself is did my advisor achieve my goal for reasonable amounts of risk and expense.
How Can I Recognize Bad Results?
If you are concerned about your returns you should not rely on the advisor who produced the returns to grade him or herself. You have to compare your results to benchmarks that are based on what you told your advisor:
- Is your goal an absolute rate of return such as 10% or do you have a relative goal such as beat the market (for example the S&P500) by 2%?
- What is your tolerance for risk: high, moderate or low?
What i Recognizing bad results is a two step process.
- Step one is determine your rate of return objective and tolerance for risk. Provide this information to your advisor.
- Your rate of return objective could be an absolute number such as 10%
- Your tolerance for risk might be low, medium or high
- Your advisor uses this information to build your portfolio
- Step two is.
- two is the development of benchmark that's based on your goals
- You select one or more indices, for example the S&P500 for stocks
- The performance of multiple indices should be based on a neutral asset allocation. For example, 50% of the S&P500's return and 50% of a goernment bond indexes return.
How Can I Predict Bad Results?
Your performance expectations are based on what you were told by the advisor. And, since most advisors create high expectations to win investor assets
