Financial planning: Be realistic about returns

Financial Planning | admin | November 2, 2011 at 5:07 am

It's good to be optimistic, but it's better to be realistic. Unfortunately, small investors often need help with return expectations. Many believe that their investments should be able to generate extraordinary returns. They believe that a return of 12% is far too unglamorous, especially if they have sought the services of a wealth manager and are paying him a fee for the advice he dishes out. The general notion is that active investment strategies should yield eye-popping returns of 20-25% per annum. Compounded, if you will.

When we invest, we participate in the economic activity around us. We give money to those who seek to build assets and, in turn, generate a return for us. At a macro level, therefore, if the economy as a whole is expected to grow at 14% (8% real GDP growth plus 6% inflation), it represents a ball-park figure about what to expect from equity investments. Considering that someone who borrows to fund an asset and generate 14% would be willing to pay only lower, the return from debt would also be lower. To park cash for a while before deploying it, one can only expect to get an inflation-neutral return. Therefore, investors considering the three asset classes—cash, debt and equity—should draw from the macro economic indicators the broad estimate of what to expect from their investments.

Earning more than what is apparent at the macro level requires active investing. It involves choosing businesses that would do better than the overall economy, besides entering and exiting them at the right times. This is easier said than done, though specialist investment managers have estiablished elaborate structures and processes to identify worthwhile investment opportunities and manage a portfolio for above average returns. If these managers charge a fee of 2.5% to deliver excess return, they should be able to earn a return of 4-5% higher than the average, to make it worthwhile for investors.

However, many investors find it difficult to accept a return of 14-16% (post costs). First, they fail to see this number as the average that can be obtained over a long period of time. Given economic and business cycles, and a dynamic macro environment, no economy or business can generate a constant return on assets. Good years are interspersed with bad ones, and returns tend to even out over the long term. Several investors demand a risk-free return as well a guarantee that such returns will be delivered. Given their unrealistic expectations, many such investors stay out of the capital market.

Second, the volatility in the performance of assets over years, alters return expectations. A good year with a 25% return makes many believe that abnormal returns are the new norm. Investors flock to invest when equity market returns move into the abnormal territory, taken in by stories that India's macro performance has changed dramatically to produce such miraculous returns. Many do not see that good years cushion the bad ones that are part of the cycle.

Third, investors overestimate the ability of managers to deliver excess returns. They think that selection and timing skills should not only deliver higher returns, but do so at lower risks. They hold this view with respect to their wealth managers too. Expertise is equated with return performance, preferably much higher than average. There is little evidence that this is possible.

There are other behavioural factors that work against investors seeking an average and reasonable return. Given the see-saw in the markets, and the apparent super-normal profits, several generalisations and stories abound. Investors anchor their expectations for return on weak foundations of the immediate past. An index level that is well above 21,000 is needed to convince many investors that the markets have rebounced, anchored as they are to the earlier peak. That the market has run up from 8000 levels to where it now is, is lost on them. This is why investors do not do well with market timing.

Swinging between an assured return of 8-10% and an active return of 20-25%, investors fail to see that realistically achievable returns lie somewhere in between. It may also be achievable in reasonable time frames from a diversified portfolio that is constructed and monitored sensibly. The performance target that investors need to set for their wealth managers is to deliver such reasonable absolute returns. By pitching their return expectations high, investors either take on risks they are ill-equipped to manage, or end up leaving their savings undeployed.

If investing is seen as a routine activity, stripped of all the glamour and excitement of abnormal returns, we can hope to see more and more investors building wealth for themselves. And getting realistic about returns is the critical first step towards this.

Source: Economic Times