By Brian Hufford, CPA, CFP®
In a recent Vanguard whitepaper, "Required or desired returns? That is the question," authors Donald G. Bennyhoff and Colleen M. Jaconetti explain how to create an investment blueprint for a goal, such as retirement.
The authors believe that most investors improperly chart an investment course with desired returns. The primary focus of desired returns is how to achieve the highest return now. After all, shouldn't my primary investment goal be to get the highest return possible?
This desired-returns thought process has several negative consequences. It can lead to taking too much risk when recent market events are positive and too little risk when negative. It can lead to overweighting recent winners, for example, technology, real estate, and gold at bubble tops over the past decade.
------------------------------------------------------------------------------------
Other articles by Hufford:
- Retirement income for life
- Tax planning for office building groups
- Turning financial capability into a potential
------------------------------------------------------------------------------------
It also can lead to improper diversification when an investor holds only a handful of individual stocks or bonds. On the other hand, a required-returns focus starts with an investment goal, such as retirement, and creates the investment-return blueprint from the cash flows needed within an investor's tolerance for risk.
The authors state that a desired-returns focus starts with investment returns as an input: "How do I achieve a 10% per year investment return?" Meanwhile, the required-returns focus looks at investment return as an output: "What investment return do I need to accomplish my retirement goal?"
A required-returns focus starts with annual retirement savings and future retirement spending as the inputs to derive the output of the investment return needed. This may seem like a too-fine distinction, but the implications are large. Here are the pitfalls of a focus on desired investment returns:
1. A focus on desired returns can result in taking too much investment risk.
The authors recount the belief that most investors spend more time planning a two-week vacation than planning for a successful retirement. With desired returns as the focus, there may be a tendency to take more risk than may be warranted or needed to achieve a successful retirement. When the focus is the required returns needed, savings, spending, and investment portfolios are more properly aligned.
2. Conversely, a focus on desired returns can result in taking too little investment risk.
Many investors are currently frozen in low-risk, cashlike investments due to the uncertainty of current world events. These investors may be taking too little risk to have the possibility of achieving the investment returns needed to accomplish a retirement goal. In this case, the desired return is driven by the perception of risk. While no investment portfolio can guarantee a successful retirement, improperly aligning the variables of saving, investing, and spending can guarantee failure.
3. A focus on desired returns leads to favoring "money managers" over "portfolio building blocks."
When portfolio construction is driven by desired returns, the focus is on research for the best mutual funds, the best stocks or bonds, or the best money managers. There is a tendency to overlook how important it is to diversify a portfolio properly with appropriate investment building blocks that offer more diversification in pursuing a retirement goal. For example, if a portfolio consists only of individual stocks, there may be a tendency to own only large U.S. companies and to not diversify appropriately in small U.S., midsize U.S., international, or emerging market companies.
4. Desired returns focus on investments while required returns focus on the investor.
Each dentist has a unique glide path toward a successful retirement strategy. Focusing only on desired-investment returns divorces the purpose for investing from the retirement goal. Each dentist has his or her unique set of goals and facts that need to be properly aligned with required investment returns as part of an overall retirement strategy.
5. A focus on desired returns can lessen the probability of investment success.
An investor whose focus is on desired returns tends to abandon an investment strategy more quickly when the desired returns are unrealized in the shorter term. When a portfolio is built from required-returns building blocks, the ultimate investment success may be more readily supported without investor self-sabotage.
In summary, investing for a goal, such as retirement, can benefit greatly from a disciplined blueprint-like approach to building a portfolio suitable for each dentist's unique retirement strategy while putting to rest each investor's desire for specific investment returns.
Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or [email protected].
Past DE Articles
