October 23, 2008, 6:00 am

Investment Expected Returns

by: The Financial Blogger    Category: Investment, Market and Risk
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This is definitely one of the busiest times for financial planners right now since their clients want to know what is happening on the market. We rarely seen such spectacular drops and jumps on the stock market and the media just jumped on the opportunity to create a bigger event.

“It’s the worst day on the market, it was more catastrophic than 9-11”, “Things like this happen only once every century”, “back to the future:1929”. The end of the world has always sold more than anything else!

Then, you see a lot of people going back to their advisor and asking them where the hell their 6%, 7%, 8% returns they were promised a few years ago are. First of all, as an advisor, you should never promise investment returns. Second of all, you must be sure that your clients understand what expected returns mean.

Mutual funds, bonds, ETF’s, stocks, the whole market are based on expected results. The expected returns on a mutual funds or any other type of investment is the yield you should get over a long period of time. I always consider 5 years or more when I talk about investing. If your investment horizon is smaller than 5 years, you should seriously consider fixed income and money market funds (except if you are in the US 😉 ).

The thing is that if you expect to get a 7% yield over the next 5 years, you will never get 7% every year. In fact, chances are that you won’t even get a 7% return for any of those years. For example, someone who makes 12% the first year, 2% the second year, -4% the third year, 15% the fourth year and 11% the fifth year will show a 7% annualized return.

Since the stock market is not following a straight line, it would be normal to show such fluctuation. The problem is that people who invested the first year are pretty happy; they are not enchanted the second year and then, they panic during the third year of their investment strategy. They tend to forget the whole strategy and are tempted to make the following analysis: “if I made 12% the first year, 2% the second one and the third one is negative, I will hit -10% during the fourth year for sure”. The human brain is always seeking for logical patterns. If your investment returns drop two years in a row, you become absolutely sure that the fourth year will be catastrophic.

This is why it is so important to get back to the expected return definition and to remember that your investment will show better and worst result than your expected investment yield. But in the end, if you have enough guts to stay in the boat while it’s rocking, you will earn your 7% annualized return!

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Comments

Great information! Thanks for posting this. I am still learning and trying to understand the economic issues that have taken place over the past several weeks. I now feel that after reading this post, along with Jose Roncal and Jose Abbo’s newest book, “The Big Gamble,” my understanding of the market is getting better.

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