In Charles Dickens’ critically acclaimed novel “Great Expectations” the central character Pip spends most of his young life chasing what turned out to be a wrong set of expectations for himself. Pip may have been blinded by the promise of wealth and stature or he might have just been confused about what he really expected from life in order to be truly happy. In either case, one lesson that can be learned from Dickens’ masterpiece is that great expectations may not be as fulfilling as appropriate expectations.
This lesson is critically important for investors. At Sapient we believe having appropriate expectations, as it pertains to portfolio returns, is perhaps the strongest predictor of success. The key is to determine what expectations are appropriate for you as an investor. Defaulting to, “I want to make as much money as possible” is not sufficient in our opinion. Real world factors such as risk of absolute loss of capital, investment volatility and liquidity requirements often help define the way you should approach investing. Thus it is imperative that investors identify the constraints they have on their money before they form investment strategies and expectations surrounding those strategies. Additionally, it is essential that investors have a goal for their investment capital. All investors should begin by asking themselves one simple question, “What do I want this money to do for me and when?” The answer to this question will form the basis for creating a strategy designed to attain the goal(s).
Imagine you have decided you want to get in better physical shape. Without defining exactly what “better physical shape” means it is impossible to define success or failure, or create a game plan designed to get you there. In the world of wealth management, the same is true. Many investors set out to find opportunities to achieve high returns in an effort to make as much money as quickly as possible. And that is where their strategy begins and ends.
At Sapient, we firmly believe investors, with the help of competent advisors, are best served by looking to the future and establishing goals for their investment capital. We believe it is far more sensible to look at a projection of future college expenses and begin a savings plan targeted to accumulate the necessary funds than to have a hit or miss savings strategy. Hope, we have found, is not a good strategy. The same can be said for retirement and estate planning. At Sapient we believe our clients should begin their life-long financial planning journey by establishing goals and then design specific investment strategies to achieve those goals. We have found the greatest success and satisfaction amongst our clients has come from having defined goals and strategies designed to attain their goals coupled with appropriate expectations.
Once goals are established, the job of creating a path to success must be completed. This is where expectations play a critical role. If you are 60 years old with $500,000 in savings and have a goal to retire with $1 million at age 65 you would need to achieve an annual rate of return of approximately 14.5% if you did not contribute additional monies. In the current investment environment this is not a realistic expectation. So what is an appropriate expectation in this case and how might it be determined?
At Sapient, we utilize a building block approach to portfolio construction. Each building block or asset category employed has a specific role in a client’s portfolio and has a range of expected returns based on historical experience and current valuation metrics. Because a primary goal for clients is to maintain the purchasing power of their investment capital, we look at how much each asset has historically returned relative to the rate of inflation, we then look at the current valuation of the asset class and make an assumption about the potential return for the client’s investment horizon. We start with money market instruments and work our way up the risk pyramid to generally higher volatility/risk assets such as stocks and commodities. Once we have assigned an expected return range for each asset class we blend that with the asset allocation profile we have determined with the client to arrive at an estimated expected rate of return for the portfolio. Obviously, we are not clairvoyant and we do not expect to accurately predict the returns for any client but we believe we are able to frame a range of possible returns based on reasonable probabilities.
So for the 60 year old with $500,000 trying to get to $1 million dollars in 5 years with a moderate risk portfolio, we might advise her that a more reasonable return expectation, based on our building block approach, might be closer to 4% today. Thus forcing further discussion as to the timing of her retirement, her risk profile and or the amount of additional funds required to accelerate the growth of the portfolio over the next 5 years. This example is for illustrative purposes only and not to be construed as a specific template for any particular investor, as each investor’s particular circumstances are important to consider.
The salient point, in our opinion, is that investors must have a clear set of goals and a methodology for creating appropriate expectations tied to their investment strategies. If either element is missing you are just shooting in the dark and your probability for success is very low assuming you can even determine what “success” means. A skilled advisor will provide guidance and structure for an investor to accomplish these essential steps.
Just as Pip ultimately recognized that expectations built on a faulty foundation did not lead him to his goal of happiness, we believe investors are better served by establishing clear goals and attaching appropriate expectations to the strategies designed to attain those goals. We have found this approach to be not only more successful but more gratifying.