Recently I was gifted a book of fables. Although these stories are well over 300 years old, they are surprisingly relevant even today. Times may change but it appears that human nature, for better or worse, is stubbornly consistent. The morals of these fables hold true to this day.
Take the fable ‘Killing the Golden Goose’ which follows:
There once was a farmer who possessed the most wonderful goose you can imagine, for everyday he visited the nest the goose had laid a beautiful, glittering, golden egg. The farmer took the eggs to market and soon began to get rich. But it was not long before he grew impatient with the goose because she gave him only a single golden egg a day. He was not getting rich fast enough. Then one day after he had finished counting his money the idea came to him that he could get all the golden eggs at once by killing the goose and cutting it open. But when the deed was done, not a single golden egg did he find and his precious goose was dead.
The moral of this fable is clear to see – greed overreaches itself and being over greedy leads to the destruction of the source of benefits to a person.
If there was a fable tailor made for the investment industry this would be it!
When questioned about investment goals some investors reply: ‘maximize returns, make me as much money as you can’ or ‘I want to beat the markets on the upside but capture none of the downside’. Not only is this unrealistic but it is actually impossible. The higher the return expectations, the greater the risk that must be incurred (risk in the investment world is manifested as volatility). Volatility is defined as the degree of variation of a trading price series over time. And volatility is a cruel mistress, it will be more than happy to give you plenty of excitement when prices are rising and euphoric but it will punish you mercilessly and without warning on the downside. It’s best to remember the markets ‘giveth’ and the markets ‘taketh’ away.
So this might leave some people scratching their heads as the industry tends to reward the highest performers as measured by absolute rates of return. Some Investment Advisors market to clients and prospects with taglines and pitches about getting you the maximum returns. Isn’t bigger better? Aren’t we supposed to chase high returns all the time? Isn’t that what we’ve been programmed to think? Mutual fund managers win awards and are given ‘stars’ if their fund had the highest return in a given category the past calendar year. And many people will flood money into that fund the following year thinking that this portfolio manager can somehow shoot the lights out year in and year out. (He/she can’t if you’re wondering.) Chasing performance is like driving by only looking in the rear-view mirror, at some point you’re going to crash.
We aren’t denying that good performance is important and critical to achieving your goals. However, the focus should be on risk adjusted returns. A risk adjusted return purifies an investment’s return by measuring how much risk is involved in producing that return. Two people could achieve a 6% rate of return by the end of the year, yet their experiences getting to that number could be vastly different. The goal of an investor or portfolio manager should be to achieve appropriate returns for a given level of risk. I.e., it is not to chase the highest absolute number, but rather to define what level of risk a person is willing to bear and then within that context and parameter produce the best return for that situation. If this is the goal, it creates an entirely different flow of communication between a portfolio manager and a client.
But how do you define what that level of risk is? Asking a person about their risk tolerance can be a highly subjective question. This is where choosing which Investment Advisor to work with becomes one of the most important decisions you make in your life.
The way to determine the risk you need to take to achieve your goals starts with a high quality financial plan. The plan is the foundation for everything else that comes after and it is used to map out the strategy going forward. A high quality Certified Financial Planner walks you through a process that ultimately results in determining the ‘numbers’ you need to achieve your dreams. The plan takes into account where you are today, how much you spend and save, what your goals are, how long until you need to start drawing from your investments and how to do so in the most tax efficient way. And that determines how much risk you need to take to get there.
Most people are surprised to learn that they don’t need to achieve double digit rates of return in order to satisfy their goals. So, if you only need to get a 4% annualized rate of return net of fees why stretch to get 20% a year when that 20% could come with a lot more risk and volatility?
And, an often overlooked benefit of financial planning is that the plan keeps you on track. Emotion does not come into play. Instead of focusing on short term results and the minutiae of line by line stock prices, your planner ensures that your overall situation is still moving in the right direction regardless of short term market gyrations, or, even bigger events such as recessions, corrections and bear markets. Returns are not linear, you will not experience a steady 4% return year in and year out, you might get 4.6% one year, 1.6% the next year and 6.7% the year after that but over time the returns smooth out to get you where you need to be.
So, stop worrying about what your neighbour is getting or what absolute performance numbers one manager is getting compared to another. Instead, focus on how that portfolio manager got there, what the process is and how that matches up with your plan and goals. Once you start focusing on your plan you achieve clarity and ultimately peace of mind. And remember, if you try to get too much too fast you risk losing it all just like the farmer and his golden goose.