Occasionally I invite other NAPFA members (The National Association of Personal Financial Advisors) to guest write for our blog here at Yardley Wealth Management. Today we have an article from Greg Phelps with RedRock Wealth Management, a Registered Investment Advisor and Fee Only financial planning firm in Las Vegas and Henderson, Nevada. Here he writes about investment objectives and how to define them:
I always start every client’s investment planning with a discussion of their investment objectives. Over the last 17 years, I’ve heard dynamically different investment objectives. Many investors just plain miss the point, and focus on the wrong thing.
When defining their investment objectives most average investors say “I want to grow my money” and leave it at that. There’s more too your investment objectives than just growing your money.
Many investors want capital growth, some investors want income, and most investors want a mix of both growth and income. Still some investors want XX% return.
If you’ve already created your financial plan, you already know your investment objectives. Accomplishing your financial goals will require XX% return over long periods of time, and careful planning for cash and liquidity needs.
Some investors need to average 8% per year to accomplish their goals. Others only need 5% per year. Some still will need 10% or more to accomplish their lofty goals.
A word of caution here. Labeling your investment objectives as “growth” or “XX% return” can create holes in your investment plan. Small holes can lead to big leaks.
In terms of “growth” or “income”, most every investment portfolio is going to have components of both growth and income. It’s hard to avoid. So for our purposes defining the investment objectives as growth and income is satisfactory since that covers most investors (whether they realize it or not).
“XX%” rate of return over time can be very misleading. Take for example 10% rate of return over the rest of your life expectancy which is 20 years or more (for example). 10% may be an aggressive – nearly out of reach – goal for your portfolio. Yet even if you attained it you may not be keeping pace with goals from your financial plan.
Focus instead on the real rate of return. The real rate of return is what you actually earn after all fees, expenses, taxes and inflationary pressure is taken out.
If you average a 10% rate of return (which I’d caution never to assume, even in a 100% equity portfolio) over the next 20 years it may look great on the surface. Who wouldn’t want a 10% annualized rate of return right? However inflation has averaged nearly 4.5% per year for over 40 years now.
That 4.5% eats away at your 10% return. Taxes will eat away at the 10% return. Fees and commissions will eat away your 10% return. That leaves you with less than 5.5% in real investment return.
Overly (and devastatingly) simplistic financial calculations don’t take the fees, expenses, taxes and inflationary factors into account. Rather the average investor sees a million dollar portfolio generating $100,000 per year from total return and thinks they’re set for life! This is not always the case.
Worse yet, there are periods in time when inflation will be above 4.5% average per year. What happens in extended stretches of time when inflation is 5.5% or greater for example? Your investment returns shrink to 3.5% or less.
Investing is like flying. You need a pre-flight checklist to get your financial game plan in order. But once the pre-flight checklist is done you power off and hit cruising altitude. Headwinds, storms and jet streams will push you off course once in a while. What’s important is making the necessary corrections to land on target.
Your investment management and financial planning must be monitored regularly. Always revisit your investment objectives to make certain they’re still accurate today. Corrections must be made when necessary, because straying too far off target can lead to a crash landing.
