Realistic expecations key to mental strength and achieving end-capital goals

For the past 15 years, investors have been over-expecting and under-achieving portfolio return targets. The great majority of investment advisors and managers have been aiding and abetting the shortfalls with unrealistic projections and passive and perpetual equity allocations that hope to outrun the reality of over-priced assets.

I thought that the below clip was useful on several points including the purpose of IPO’s (to get founders liquid) as well as the shortfalls in the latest round of economic fix ideas out of the US and Europe. But most importantly, El-Erian explains the math of rational portfolio return expectations over the next few years where realistically fixed income may return 3% and equities may return a compound 4 to 6% a year.

It is very important to do the math on these return targets and what they mean for real life investors. I offered very similar math in my book Juggling Dynamite, only since then fixed income rates have dropped from about 5% then (in 2007) to 3% today, so return expectations today are even lower. On a balanced portfolio realistic hopes calculate as follows:

50% weight (equities) x 4 to 6% = gross return of 2 to 3%
50% weight (fixed income) x 3% = gross return of 1.5%

=Total gross compound annual return targets of 3.5% to 4.5%

-less any portfolio fees, commissions or mutual fund expense ratios (many services are still gouging in excess of 2%).

This is the reality of math in today’s low interest rate and over-priced stock market. Risk-sellers will seek to “augment” portfolio promises with a greater than 50% weight to equities. But in the midst of an ongoing secular bear where stocks typically lose 30-50% of their value every 3-5 years, upping the risk exposure in one’s savings (especially on the typical buy and hemorrhage plan) is a devastating idea.

In addition even for the brave, naive or desperate who sign up for hopes of ‘average returns’ over time, very few are able or willing to endure the dramatic swings and risk that passively allocated capital must face while trying to garner this relatively small upside.

Buying or holding at over-valued equity levels means that in order to try and garner the 4-6% annual target on one’s stock holdings, you must first strap your peace of mind and liquidity to the front of the Behemoth roller coaster. Where it stops or where necessity or emotion requires one to take capital off, dictates everything about outcomes for individuals.

What does this mean for investors? First El Erian admits return “promises that have been made in the past will be very hard to sustain.” Such a relief to hear an investment guru admit truth on this. The truth is that rather than running the risk table, investors will be best served by expecting less (may need to spend less) and saving more over the next few years in order to meet end goals.

It also means that managers need a much more careful tactical approach to asset allocation than buy and hope if capital is to survive and grow. Risk management rules that are disciplined and won’t allow us to buy at every price while also designed to limit down market losses are key to mental strength and financial security as we work our way to the end of this secular bear.

Mohamed El-Erian, CEO and co-CIO at PIMCO, says Paul Ryan’s definition of “misguided policies” are different than his own. He also offers insight on realistic portfolio return targets over the next several years. Here is a direct link.

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