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What is the difference between your required return and your desired return?

| August 15, 2016
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Over the years, we have heard phrases like “I’d like to earn 10%” or “I think I need to earn around 8%”. These statements and possible returns are typically influenced greatly by media, advertisements or even advisors reaching for new clients.  They are baked in behind emotions without math.  After all, higher returns are better, all else equal right?

For those of us who struggle in the patience department, the stock market has tested us greatly for the past several months as volatility seems to have us on a treadmill-- we’re doing a lot of walking but don’t seem to be getting anywhere!

So our lesson in patience today reminds us that your required return is based on data and analysis of your financial plan.  It is the return needed, taking into account your time horizon, asset base, liquidity needs, savings behavior, tax sensitivity and risk tolerance among other factors, that helps you accomplish your objectives.  This return is typically an inflation adjusted return with an assumed inflation rate over the investment horizon.  It helps frame the investment strategy around you specifically rather than the pursuit of returns more generically.

A return objective different than the required return can be viewed as your desired return.  This number can be influenced by past experience, expectations set by historical returns, or the investment media in general.  It can be influenced by a conversation with a friend at a party.   It is a number based on what you want vs what you need.  Not surprisingly, your desired return is often much higher than the required return.   This request for a particular desired return can often result in an allocation skewed toward higher risk assets which in turn can lead to problematic investment outcomes and damaging the overall financial plan.

Many investors will find that the return necessary to achieve their long term goals is meaningfully less than their desired return.  This means that their portfolios can include higher allocations to assets with less expected volatility.  These less volatile returns, over time can add to the probability of the success of the financial plan.  In turn a higher probability of success helps you or your advisor avoid the temptation of making radical changes during times of market duress. 

So higher returns are better all else equal right?   Remember with investing all else isn’t equal.  Do the math.

 

There is no guarantee that the implementation of a financial plan will yield positive results. All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protection against a loss.  Securities and advisory services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC.

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