Being Realistic About Prospective Returns

This is an important part of getting the sums right when you play with the calculator but also is an essential part of finding your feet as a portfolio investor. You will probably already be aware of the trade-off between volatility of returns and extent of returns you can capture. In general terms they are inversely related – pursuit of high returns is most often accompanied by greater fluctuations in the year-to-year performance of your portfolio.

This needs to be understood, so that the investor appreciates the risk they take with a particular investment strategy. It’s not uncommon for portfolios focussed on growth, not being in a position to be tapped when you have a need to take funds from it. Generally, the older one gets the more volatility-averse the investment strategy becomes, simply because your ability to replenish the fund should a poor investment experience deplete it, is limited. When you’re younger you have both the time and the income to top it up – when you’re older and retired you may well not.

So don’t expect that the investment strategy appropriate for you will remain constant as the years pass. As you age, you will end up sacrificing potential returns for the security of greater certainty of return.

Over the period, 1926-2000, the returns (after inflation) from the US, the world’s largest market averaged;

Stocks 8% per annum

Bonds 3% per annum

Cash 0.8% per annum

Now these returns are pre-tax. So for an investor paying tax (at 33% say) on income (which means all the return from bonds and cash and the dividends from stocks) but not on capital growth, the post-inflation, post-tax returns in a world where inflation has averaged 3.2% pa inflation would have been

Stocks 6.6% per annum

Bonds 1.0% per annum

Cash -0.5% per annum

So a portfolio of stocks, bonds & cash in proportions 50/30/20 say would have returned 3.5% pa after tax and after inflation.

Now this assumes the investor had the appropriate knowledge and discipline to attain market average returns (only 30% of investors historically have managed market average or better returns). Even assuming the investor does have these skills, the 3.5% pa does not make any allowance for the cost of the time taken by the investor to run their portfolio.

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