What Rate of Return Can You Expect from Your Portfolio?
Your estimate can help you figure out what asset allocation best suits your risk tolerance and financial goals.
My last Kiplinger article introduced the latest book by Micahel J. Mauboussin, The Success Equation, in which he makes the argument that events in business, sports, investing and even life can be looked at as part skill and part luck. The trick is to figure out whether skill or luck has a larger impact in any particular activity.
The part of the book that interests me the most is the discussion of investing, and how it is an endeavor that involves a high degree of luck. So much so, in fact, that the influence of events outside of our control (luck) can overshadow skill, good processes and past strings of either good or bad results.
In such a situation, the author recommends following checklists and ensuring that a solid, repeatable process is followed. Before we can even begin to consider evaluating investments for implementation, we have to establish our goals.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
How do we do that? I propose the following procedure:
1. Determine the appropriate allocation (or diversification strategy) for your portfolio. My firm does this by evaluating a client's sensitivity to volatility (risk tolerance), using a state of the art tool called Riskalyze.
2. After getting a feel for your risk tolerance, consider other aspects of your life, such as career stability, stage of life (growth years, retirement, distribution, etc.), financial situation in terms of emergency funds, savings, debt, need to pay for education, etc. Then, make a determination about what your expected return needs to be. Should it be 6%, 8%, 11%?
3. A rate of return can be backfitted into your portfolio by using the latest estimates of what different asset classes have returned over a period of time, as well as inflation expectations and other factors.
To give you an idea of how subjective this is, and how a qualified fiduciary adviser can earn his or her keep, here's an excerpt from Dimensional Fund Advisors latest "Matrix Book," an invaluable resource for making informed decisions of this type:
As a back-of-the envelope estimate, let's go with the most recent 20 years and the following basic asset classes:
U.S. Stocks – S&P 500: 8.2%
International – MSCI EAFE: 4.4%
U.S. Small Cap – Dimensional US Small Cap Index: 11.5%
Bonds – Barclays US Aggregate Bond Index: 5.3%
Your expected return is going to equal the sum of the returns of each of the above benchmarks multiplied by its expected weight in your portfolio. For example, let's say your risk tolerance score recommends you build a balanced portfolio of 60% stocks and 40% bonds. Also, let's say that you've decided that 10% of the portfolio should be in small company stocks and 10% in international. Your expected overall return should be: 8.2% x 0.4 + 4.4% x 0.1 + 11.5% x 0.1 + 5.3% x 0.4 = 6.99%. That's before inflation, money management fees, etc.
Now we have a decision point. Is 6.99% appropriate for you? Or do you need more of a return? A case can be made that if you are in the growth stage of your career and income, the entire portfolio should be weighted toward large and small domestic stocks, which should significantly impact your returns (and also the volatility of the portfolio). Realize too, that there are many other asset classes we can consider&mdsah;emerging market stocks, different classifications such as growth, value, or blend, mid-cap stocks, commodities, real estate, "smart beta", etc. These may add incremental returns to our portfolio, depending on the type of asset.
If you're happy with the return expectations using only indexes and benchmarks to guide you, a passive indexing approach may suit your needs just fine. You will minimize one component of portfolio drag—expenses, as most index funds and exchange-traded funds will have overall expense ratios of 0.5% or less.
Whatever your needs, this process can help you make better decisions when choosing mutual funds and ETFs. You can even crunch your own numbers, using the Portfolio Expected Returns Calculator I've created.
Doug Kinsey is a partner in Artifex Financial Group, a fee-only financial planning and investment management firm based in Dayton, Ohio.
Doug Kinsey is a partner in Artifex Financial Group, a fee-only financial planning and investment management firm in Dayton, Ohio. Doug has over 25 years experience in financial services, and has been a CFP® certificant since 1999. Additionally, he holds the Accredited Investment Fiduciary (AIF®) certification as well as Certified Investment Management Analyst. He received his undergraduate degree from The Ohio State University and his Master's in Management from Harvard University.
-
Use An iPhone? You May Be Hearing From A Class-Action Lawsuit Group
A handful of suits against the iPhone maker seek to crack down on everything from app store purchases to messaging.
By Keerthi Vedantam Published
-
Capital One/Discover: What's In Their Wallet For You?
Push back on Capital One's planned merger with Discover is growing with one group of consumer advocates calling for a public hearing.
By Keerthi Vedantam Published
-
Should You Enroll in Medicare if You Still Have a Job?
This question is being asked more than ever these days, so here’s what you can do when it comes to making Medicare decisions while you’re still working.
By Jae W. Oh Published
-
Three Big Ways That Life Insurance Can Be a Lifeline
Life insurance not only provides a safety net for loved ones and leaves behind a lasting legacy, but the cash value can also help during financial hardship.
By Steve Sugumele Published
-
Romance Scams That Target Older Adults Rising: What to Do
Here are some tips to help you avoid falling for a scam, especially when a scammer tries to prey on your affection.
By Patrick M. Simasko, J.D. Published
-
Lessons Learned From Britney Spears’ Financial Conservatorship
The pop star’s recent memoir reveals the toll her involuntary conservatorship took on her and spotlights the drawbacks of these legal arrangements.
By Stacy Francis, CFP®, CDFA®, CES™ Published
-
Four Things to Know About Managing a Loved One’s Finances
Figuring out when it’s time and knowing how to talk about it are just the start. You also need info about estate plans, insurance and health care decisions.
By Tony Drake, CFP®, Investment Advisor Representative Published
-
Avoid Surprises: Don’t Procrastinate on Your Taxes
You really should start thinking about next year’s taxes immediately after filing this year’s. Better tax efficiency could save you some serious dough.
By Jared Elson, Investment Adviser Published
-
How Gig Workers Can Prepare Their Estate and Financial Plans
Freelancers have to be vigilant to keep track of where their money goes, whether it’s to cover daily necessities, saving for retirement or other expenses.
By David Handler, J.D. Published
-
When Flying Toward Retirement, Secure Your Own Mask First
Parents often feel compelled to help their kids pay for college, but when that could result in you moving in with them later, you should put your savings first.
By Andrew Rosen, CFP®, CEP Published