Managing expectations for investments
Joel Dresang: Kyle, one of the roles of an investment advisor is to manage expectations. We’ve got the second longest bull market for stocks in history. We know that stock prices generally aren’t real cheap right now and that interest rates are coming from historic lows and gradually going up. What should expectations be right now?
Kyle Tetting: I think first and foremost, investors need to remember that just because we’ve had an extended bull market, just because returns for stocks have been exceptional the past few years, it doesn’t necessarily mean that that has to come to an end. It’s really important to remember that while expectations may shift a little going forward, it isn’t necessarily all bad.
I think what we do need expect, though, is that returns for stocks as we look ahead may not be quite as exceptional as they’ve been in the past few years. And so certainly, as you look at your portfolio, there’s some room maybe to reconsider some of your allocations.
Joel: You’re talking about expectations for returns. What about for risk?
Kyle: It’s really important to point out that it’s been a low volatility period as well, not just a strong return period. And so, investors also probably need to expect a little bit more volatility in their portfolio, especially from the stock side. But more importantly, it’s not just risk or return, but the relationship between risk and return.
We’re very fond of pointing out that relationship because investors need to expect a certain level of return for the level of risk that they’re willing to accept. We call that the risk premium. What premium should you demand as an investor for the level of risk that you’re taking in your portfolio?
Joel: So, the efficient frontier. We use that as a way to illustrate that interplay between risk and return.
Kyle: Absolutely. So, that chart for the efficient frontier I think is one of the best ways to really illustrate the additional premium that you can expect for the level of risk you’re taking. And what we really learn from that chart is that you really take on more stocks then you otherwise might need, you’re not being compensated to take additional risk.
And so you look at that efficient frontier at what would be a portfolio of 60% stocks and 40% bonds, and you can expect a return over the last 30 years, or at least you would have expected a return of somewhere around 9.2%.
But take a step out and go to maybe an 80% stock and 20% bond portfolio –a fairly meaningful shift in allocation – and investors could expect another five-tenths of a percent return to 9.7%.
But when you look at the standard deviation or the volatility of the portfolio you’re talking about a pretty significant increase in volatility – 25% more volatility between those two portfolios.
I think it really reminds investors that they need to make sure that they’re being appropriately compensated for the level of risk they’re taking. And its’ important to point out that that’s based on historical data, looking back at the last 30 years – not necessarily what we expect going forward.
Joel: What about going forward? How do you take that into account?
Kyle: Well Joel, if we really are talking about a shift in expectation for risk and return, I think it’s important for clients to take a look at their portfolio and make sure that it properly reflects that.
But as our expectations for return come down a little bit, as our expectations for volatility maybe go up a little bit, many investors are going to be more comfortable, and it’s going to be a better place to be on the efficient frontier moving back now down toward that 60-40 or even a 50-50 portfolio, just again, based on those expectations for the future.
And, ultimately for investors, what they really need to make sure is that the portfolio that they have is appropriate for their expectations.
The ups and downs of volatility, a Money Talk Video with Steve Giles
Efficiently allocating assets, a Money Talk Video with Steve Giles
Investment insights via Morningstar snapshot, a Money Talk Video with Tom
Risk: How much can you stand? How much do you need? a Money Talk Video with Isabelle Wiemero
What investors need to know about volatility, from the Financial Industry Regulatory Authority
Asset Allocation, from the Financial Industry Regulatory Authority
(initially posted June 2, 2017)