As a registered investment adviser, I am often asked, “What kind of returns are you getting?” I believe they ask this question in order to compare the performance of their own portfolio and gauge how good I am as an investor. In today’s post, I will show you this is the wrong question to ask.
The first problem with this question is that it does not address the amount of risk being taken in the portfolio – risk and expected return are correlated. One cannot have large returns without taking large risks. There is an overwhelming body of evidence demonstrating that active management of a portfolio, meaning picking stocks and timing the market, is a losing strategy. Once accounting for style premiums (beta, small, value, momentum and profitability) very few investors beat the market over long periods of time. If you are getting above average returns, then it is probably luck (unless you’re Warren Buffett).
In order to demonstrate the relevance of portfolio risk, imagine a portfolio made up entirely of the mutual fund DFSVX. In 2012 this fund yielded a return of 21.7%, which compares favorably to the S&P 500’s return of 16.0%. However, this mutual fund is a small cap value fund – much more volatile than the S&P 500 and gains exposure to additional risk factors (size and value). In fact, all of the fund’s “alpha” can be explained by having exposure to those risk factors. Due to these additional risks, mutual funds like this can easily underperform for long periods of time.
The only way to have high returns with lower risk is to aggressively diversify your portfolio across asset classes, geography and style premiums. But this is only part of the story. Depending on your personal situation, you may want to take more or less risk than someone else. Only asking someone about their returns misses this point. If you asked one of my clients what kind of returns he got last year it might sound low. If you asked another it might sound high. The client getting low returns is likely either close to or in retirement, or has sufficient assets to fund his financial goals without needing to take on additional risk. The client getting high returns probably has stable income from employment, is years away from retirement and is willing to take on these risks.
Further, this highlights the importance of having a wealth manager held to a fiduciary standard rather than a typical investment manager. A wealth manager held to a fiduciary standard looks at the complete view of a family’s financial situation; an investment manager usually takes a portion of client’s net wealth and tries to get the highest return he can with it. Hopefully you and your advisor take the time to develop future financial goals. Then, using reasonable projections of asset class performance, you project how much risk is appropriate in order to accomplish these goals. Only in this context is the question, “What type of returns are you getting?” appropriate.