When my father taught me how to sail, one of the first lessons was that steering an accurate course and paying attention to the compass were important. A compass has 360 degrees, and being off course by a single degree may not seem like a big deal. However, over a distance of 1,000 miles, a 1-degree mistake means that you’re a little more than 17 miles off target. For a ship bound for Boston from London, being off course by only a couple of degrees means that it might miss the state of Massachusetts entirely. It’s amazing that the early mariners ever found their destinations.
Investing poses a similar problem for many investors: How do they set the right course to achieve their financial goals? And, once set, how do they appropriately measure their progress along the way? Clients often struggle with these questions, and their confusion can frequently result in some challenging conversations for advisors. An understanding of a client’s required return can help.
What, why, how?
What is the required return?
The right course for clients to follow to achieve their financial goals is not set for them but by them. It’s not random or extraneous—to ”beat the market”—but personal and calculated, based on their objectives, risk tolerance, tax circumstance, and the many other factors that are inputs into their financial plans. It’s all about them, considering not only their financial circumstances today but also estimates of what assets they would need in the future.
The output of this planning is the clients’ required return, an estimate of the return needed to achieve the goals that the clients said were the most important to them as derived from the financial planning process.
Why is it important?
The required return can help demystify and personalize the investing process. It serves as a guide for selecting the asset allocation that best suits a client’s circumstances and risk tolerance based on your risk-and-return expectations.
During this process, you can help a client vet the priority of his or her goals. For example, a client states that she wants to cover college expenses for her two children, invest for a comfortable retirement, buy a vacation home at some point, and leave a large bequest to her alma mater. While these may be important goals to consider, should they all be equally important? Probably not, since most clients would likely not sacrifice college educations for their kids to buy a vacation house or donate the funds they need for retirement expenses to their favorite college. Without prioritization, the target wealth needed to meet all these goals would inflate the required return and probably lead to a riskier portfolio than needed.
How can it be used to help clients?
“Beating the market” is a common return desired by clients, but it’s arbitrary. The required return is not. It’s the return your clients need and can help answer some of their tricky questions.
How should you select a client’s asset allocation for the portfolio? The required return is your guide.
How do you know if a client’s portfolio is on track to achieve the client’s goals? The required return is your benchmark for success.
Baking in the hot sun on a slow-moving sailboat can really motivate you to get where you’re going as quickly and directly as possible. And for many clients, the pursuit of higher returns seems like a simple parallel to an expertly charted course. After all, higher returns build wealth faster, enabling clients to reach their goals sooner. However, as we know, higher returns are usually associated with higher risks, and overreaching for returns can often lead to wealth destruction rather than creation.
Using the required return can help both to clarify and to personalize the investing process for clients. It provides context for the asset allocation decision by helping them see that the investment strategy you’ve built for them is tied to the return they need to achieve the goals they said were the most important. What could be easier than to help your clients see that the best course and speed for them is the one set by them?