Advertisement
Investor Psychology

Investors: Focus on Cash Flow, Not Returns

Investors who zero in on their portfolio’s bottom line are missing the point, and they could be pressured into making a costly mistake.

Thanks to the financial services industry, over the decades investors have been conditioned to focus on the returns their portfolios generate, more than on cash flow. The industry has emphasized returns, as they make a great sales tool for financial professionals. But that hardly helps investors (more on the problem with historical and average returns in my next column).

Of course, it is important to have positive returns, but simply focusing on this elevates what I call “sequence of returns risk.” This refers to the phenomena where portfolio returns in the early part of the investment cycle have a disproportionate impact on the long-term outcome of the portfolio – ergo, a 15% loss in year one has a compounding effect that is much greater than having a 15% lost in later years of the investment cycle.

Advertisement - Article continues below

The psychological impact of this is that it often causes investors to change their investment allocation to a more conservative mix, or worse yet sell near market lows, thereby compounding the impact of the early negative returns and making achieving their investment goals much more challenging. If, however, investors were to simply focus on cash flow, then they probably wouldn’t give in to any temptations to time the market or take corrective actions during a downtown, which is a natural part of a full market cycle.

Advertisement
Advertisement - Article continues below

For instance, take two identical $1 million portfolios, which are set up to distribute $50,000 annually. Investor No. 1 has the unfortunate luck of investing at the peak of the market cycle and being subjected to two negative performance years at the outset. Investor No. 2 experiences positive returns for the first two years.

YearPortfolio 1
annual return
Ending balance after
$50k distribution
YearPortfolio 2
annual return
Ending balance after
$50k distribution
1-5%$945,000110%$1,050,000
2-3%$866,650220%$1,210,000
310%$903,3153-3%$1,123,700
47%$916,5474-5%$1,017,515
5-15%$729,06557%$1,038,741
620%$824,8786-15%$832,930
71%$783,12778%$849,564
8-3%$709,6338-3%$774,077
98%$716,40497%$778,263
107%$716,552101%$736,045

Average annual return for both portfolios = 2.7%

Experience has taught me that investors like Investor No. 1 will likely become nervous, and at the very least will doubt their strategy and be tempted to sell. Both portfolios have a 10-year average annual return of 2.7%, and both distribute the desired $50,000. The ending balance between the two portfolios is about $20,000 apart, well within a reasonable margin of error for long-term investment return expectations.

Astute investors know that portfolio returns are heavily influenced by market cycles, which are uncontrollable. By focusing on cash-flow, investors are better able to ignore short-term market gyrations and sequence of returns risk. In my next column, I’ll be discussing the importance and significant impact portfolio costs have on long-term performance.

This column is the third in a six-part series on investor education.

  • Column 1 – Understanding your goals
  • Column 2 – Why benchmarking to the S&P 500 is not a good strategy
  • Column 3 – It’s about cash-flow, not returns
  • Column 4 – How much are you paying for your portfolio?
  • Column 5 – 5 critical questions to ask your financial advisor
  • Column 6 – ‘Senior Inflation’ the not so silent retirement killer
Advertisement

About the Author

Oliver Pursche, Investment Adviser Representative

CEO, Bruderman Asset Management

Oliver Pursche is the Chief Market Strategist for Bruderman Asset Management, an SEC-registered investment advisory firm with over $1 billion in assets under management and an additional $400 million under advisement through its affiliated broker dealer, Bruderman Brothers, LLC. Pursche is a recognized authority on global affairs and investment policy, as well as a regular contributor on CNBC, Bloomberg and Fox Business. Additionally, he is a monthly contributing columnist for Forbes and Kiplinger.com, a member of the Harvard Business Review Advisory Council and a monthly participant of the NY Federal Reserve Bank Business Leaders Survey, and the author of "Immigrants: The Economic Force at our Door."

Advertisement

Most Popular

18 Things You Can't Return to Amazon
Smart Buying

18 Things You Can't Return to Amazon

Before tossing these items into your virtual shopping cart, be sure to read Amazon's return policy first.
September 17, 2020
Election 2020: Joe Biden's Tax Plans
taxes

Election 2020: Joe Biden's Tax Plans

With the economy in trouble, tax policy takes on added importance in the 2020 presidential election. So, let's take a look at what Joe Biden has said …
September 18, 2020
Insurance for Long-Term Care at Home
retirement

Insurance for Long-Term Care at Home

In the wake of COVID-wracked nursing homes, increasingly more people are looking at options to age in place with long-term care insurance.
September 17, 2020

Recommended

Bonds: 10 Things You Need to Know
Investing for Income

Bonds: 10 Things You Need to Know

Bonds can be more complex than stocks, but it's not hard to become a knowledgeable fixed-income investor.
July 22, 2020
Insurance for Long-Term Care at Home
retirement

Insurance for Long-Term Care at Home

In the wake of COVID-wracked nursing homes, increasingly more people are looking at options to age in place with long-term care insurance.
September 17, 2020
A Step-by-Step Guide to Being an Estate Executor
retirement

A Step-by-Step Guide to Being an Estate Executor

Whether you’re planning ahead for your own heirs or have been asked to serve as an executor of an estate for someone else, it pays to understand what …
September 17, 2020
Medicare Basics: 11 Things You Need to Know
Medicare

Medicare Basics: 11 Things You Need to Know

There's Medicare Part A, Part B, Part D, medigap plans, Medicare Advantage plans and so on. We sort out the confusion about signing up for Medicare --…
September 16, 2020