Investors could be better off with lower return objectives and a less risky portfolio than the more typical higher return objective of most portfolios, a Vanguard research paper argues.
The paper by Vanguard researchers Donald Bennyhoff and Colleen Jaconetti, which Vanguard will post to its site Wednesday, points out the risk to advisors and clients of seeking even the historical average rate of return.
Titled “Required or Desired Returns: That is the Question,” the paper argues that advisors who impress this distinction upon their clients increase the probability of their clients’ investment success.
At issue is the return target that is fundamental to the advisor-client relationship. That number is very often subjective, influenced by factors such as advertisements or media reports of mutual funds’ recent returns, or cocktail party accounts of a neighbor’s investment results.
Bennyhoff and Jaconetti argue, however, that such impressions bias the portfolio and advisor-client relationship to needless risk—like “buying the building materials for a house before the architect has drawn up the blueprints.”
A better approach would be for an advisor to determine an objective return target based on each individual client’s unique goals, time horizon, risk tolerance, asset levels and liquidity needs.
The resulting required return vs. the subjective desired return has the merit, typically, of being lower and more achievable and thus requiring less portfolio risk.
The authors note that a required return approach could, however, go the other way. In other words, investors scarred by the financial crisis into embracing “safe” CD and money-market investments, preferring capital preservation over capital appreciation, may require greater return and risk than they desire.
More typically, though, investors are influenced by historic average rates of return, and the authors show that such an approach can be inherently dangerous.
For example, from 1969 to 2012, a 100% stock portfolio returned 9.77% a year on a nominal basis. During the same period, a more conservative 50%/50% stock-bond portfolio performed nearly as well, yielding 9.09% per year. But the high return of bonds was made possible by a long-term dramatic decline in interest rates from an early 1980s high to today’s near-zero rates.
“The double-digit interest rate declines that fueled those well-above-average bond returns certainly are not probable in today’s environment,” the authors write.
With high returns potentially harder to achieve and not necessary to achieve, Bennyhoff and Jaconetti argue against a portfolio allocation needlessly skewed to higher-risk assets.
“Investment plans based on desired return, if higher than the required return, can unnecessarily increase the short-run volatility in the portfolio’s value, which may be more than some investors are able to bear,” they write.
Thus, a more conservative portfolio may make it more likely for an investor to stay the course. Lower return expectations may similarly make it easier for clients “to maintain their planned capital contributions through savings and retirement plans,” and the lower volatility of conservative portfolios may avoid tempting clients to abandon course in times of market duress.
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