Two quick questions. How long did you take to plan your last Christmas holidays? And how long did you take to plan your investment portfolio?
"It's often said that many people spend more time planning a two-week vacation than they do on their investment plan," say US-based Vanguard investment analysts Donald Bennyhoff and Colleen Jaconetti in an updated research paper.
"Experience suggests that this witticism is not far off the mark," Bennyhoff and Jaconetti add.
"On their own, investors often ignore the important planning phase," the analysts emphasise, "focusing instead on filling their portfolios with investments featuring attractive returns. This is akin to buying building materials for a house before the architect has drawn up the blueprints."
Their research paper – Required or desired returns? That is the question – suggests the critical first step in creating an investment portfolio is for investors, perhaps with the help of a good adviser, is to understand their objectives and their constraints. And this should involve gaining an understanding of the often-overlooked and critical difference between required and real returns.
Their paper is written from the perspective of how advisers can help their clients develop investment portfolios based on realistic expectations for returns.
"The financial planning process should result in an estimate of the return needed to accomplish an investor's objectives, taking into account that client's unique goals, time horizon, current asset base, liquidity needs, saving behaviour, tax sensitivity, and risk tolerance among other factors", they write. In other words, this is the required return.
Investors may set unrealistic desired returns based on a variety of influences including their own investment experiences (good and bad), historic returns over various periods, lists of the latest highest-performing managed funds, media reports and investment advertising.
Unsurprisingly, say Bennyhoff and Jaconetti, an investor's desired return is often much higher than their required return. In turn, this can lead to investor taking excessive risks in the pursuit of achieving those higher, unrealistic returns.
Regular Smart Investing readers may be familiar with our discussions of the importance of distinguishing between required and desired returns. And it is well-worth revisiting this research paper in the light of Vanguard's latest medium-to-long term economic and market outlook.
Our outlook emphasises that investors should ensure that their expectations for returns are reasonable or realistic in this low-interest, more subdued-return environment. It's a straightforward message that goes to the fundamentals of sound investment practice of carefully setting your objectives and then working out the best way to get there with a disciplined and realistic approach.
As Bennyhoff and Jaconetti conclude: "Headlines and hyperbole can change daily. An investor's long-term objectives, however, are far less variable."
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Written by Robin Bowerman, Head of Market Strategy and Communications at Vanguard.
Reproduced with permission of Vanguard Investments Australia Ltd
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