From the CEO’s Desk is a monthly series, sharing thoughts on relevant issues, challenges, events, questions, and experiences impacting investors today.
The worst question I received
As a former wealth manager I remember one of the worst (but very common) question prospective clients ever asked me at the beginning was about investment performance:
How much will you make me?
Having worked with many private clients in my career as a wealth manager, and now helping many individuals every day find their professional wealth managers at findaWEALTHMANAGER.com, I wanted to share some observations about why the question of investment performance should not be number one. Far more important is a conversation around understanding investment risk in order to achieve great investment performance.
“I want 10% a year investment performance”
After that initial question, the conversation would quickly turn to return expectations. “I want 10% a year!”.
What fascinates me about clients and their investment performance expectations is the level that is demanded and the lack of understanding of what is involved to achieve that.
Understandably when we invest, be that ourselves or through a wealth manager, we want to make money. But even more important, we don’t want to lose it. We’ve worked hard for it. Irrespective of the quantum, it’s precious. Yet returns, both positive and negative, are directly correlated to risk. So the higher return that is sought, the higher the risk that must be taken.
Risk precedes return, not the other way around
The term ‘risk’ is overused but understanding it is fundamental in the context of investment performance and returns.
But first, let’s consider some basic statistics:
- Today, US dollar cash rates are approx 0.4% per annum. (Reference: 3 month USD libor)
- The average dividend yield on S&P 500 equities is approx 1.9%
- S&P500 performance over the last 12 months has been 2% and over 5 years 58%
So to have a 10% return target means approx 9.5% higher than cash rates!!
That’s a huge premium. Money doesn’t grow on trees. Don’t take this at face value, really try to think what risks are involved to 9.5% more than cash deposit and 8% more that mainstream equity markets like S&P 500. In the first part of this series, we discussed common risks that many investors underestimate or don’t even realise they are taking!
But risk and return is just the first half of the equation. The second half has to do with your investment time horizon. In other words, when you do you want to achieve 10% returns – in one year vs in 10 years requires very different strategies and investment portfolios. For the purpose of this post, we will just focus on the risk side, but it is important to be aware that time is a major element in understanding returns.
A better question to ask
As a former wealth manager, I could achieve 10% or greater for my clients. So is it possible? Short answer – yes. But a better answer is – it depends.
So a better question to ask is “How can I achieve 10% a year given my risk appetite, time horizon, and financial objectives?” Regardless, the first step smart investors take is to intricately understand risk or make sure they use a wealth manager who does. Without that big losses can be avoided.
Key takeaways to win the risk and investment performance battle
- Understand your risk profile before thinking about investments. Consider your lifestage and financial ambitions and translate that to a score.
- Understand the risk profile of investments you are considering. Score them and related to your own risk profile. Did you know that international equities are high risk? Why? Because the volatility and potential to make deep losses is much higher than bonds and cash. See the table here to put investments in to risk
This is the third part to a three part series on Risk. Please check out the other posts in this series on Risk by clicking on Part 1 (“Roulette Risk – Big 5 Unknown Investment Risks”) and Part 2 (“One of the Biggest Overlooked Risks to Investing”)
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