The critical difference between desired and required returns
20 November 2017 | Portfolio construction
We probably all remember during those long difficult car trips as children repeatedly saying such irritating things to our parents as: "When do we get there?". Perhaps adding to reinforce the point, "I knew we would never get there".
And then pleading whenever a fast-food joint appears on the horizon: "I NEED an ice cream".
Fast forward to today and think how we broadly face similar fundamental, yet much more complex, issues regarding our retirement savings.
Astute investors set their long-term goals – the parallel being the destination of those seemingly-endless childhood road trips – and then work out how to get there.
And a critical challenge for investors is to make the often-overlooked distinction between the required returns from their portfolios to reach their intended investment destinations against their desired returns. (This equates to separating between NEEDING that ice cream as a child or merely just wanting one.)
The separation of desired and required returns, ideally at the beginning of the financial planning process, is truly an investment fundamental. Distinguishing between desired and required returns should help guide investors to selecting appropriate asset allocations for their portfolios given their personal circumstances including their unique goals and tolerance to risk.
In other words, the process of separating between returns in this way should assist investors narrow the range of asset allocation choices suitable for them.
An updated Vanguard research paper* – Required or desired returns? That is the question – suggests that many investors will find that the return required to achieve their long-term goals is "meaningfully less" than their desired return.
And, of course, higher returns are associated with higher risks.
The research paper ends with a twist: "Ironically, for many investors the means to a better investment outcome and greater wealth may be a more balanced portfolio with lower expected returns, rather than one focused on higher returns."
*Required or desired returns? That is the question by Vanguard investment analysts Donald Bennyhoff and Colleen Jaconetti.
Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.
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Robin Bowerman, Principal, Market Strategy & Communications at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.