Downturns in financial markets have been known to trigger bouts of introspection. Current markets seem to be no different in this regard. Some investors have seen their carefully crafted plans blown off course, possibly not for the first time, as returns they had expected have turned out to be in excess of those ultimately earned. How have investors found themselves in such a position?
Investors’ plans often rely on a combination of capital and growth to reach an ultimate goal. The base case for this growth is the ‘risk-free’ asset, to the extent that the risk of default can be eliminated. Generally, the risk-free asset is considered to be cash or a government bond reflecting the term of the investment plan. Investors might seek to earn a return in excess of that available on the risk-free asset in exchange for taking on a degree of risk that the ultimate return falls short of that available on the risk-free asset. The range of potential factors contributing to this shortfall is beyond the scope of this short piece. The current environment of low, and sometimes even negative, risk-free rates is causing many investors to seek excess returns to meet their goals.
The excess returns are not guaranteed but involve the taking of some risk. If the returns were truly guaranteed, why would the guarantor want to pay anything above the risk-free rate? However, some investors seem to treat these excess returns as guaranteed in their planning process. How can such an approach be considered prudent? Perhaps it is received wisdom/common knowledge/historically proven/intuitively obvious/the way it has always been done (take your pick) that certain assets will outperform the risk-free rate? Might it be the persuasiveness of the product provider and/or their representative? Whatever the case, what demonstrable skills do those who are making the forecasts of excess returns have in doing so? How are their interests aligned with those of the investors whose capital is at risk based on these expectations?
Might investors not be better served by an alternative approach that takes no account of excess returns over the risk-free rate into account upfront? This suggestion does not mean that the potential upside should be ignored in its entirety but rather is considered as one scenario among a range. The upside scenario would be accompanied by a corresponding downside scenario to reflect the circumstances where risk taking incurs a penalty instead of earning a premium. Current low risk-free rates mean that the base (i.e. risk-free) level of growth might appear to be low but that is simply reality. Every other asset is grounded in this same reality, with a corresponding impact on the base level of returns.
Investors should, ideally, monitor their plans from time to time. This periodic monitoring creates a natural point for the outcome of risk taking over the period to be assessed and for plans to be modified accordingly. Those who have generated excess returns will be able to reduce their future capital contributions if targeting the same outcome. Others who have not been able to keep up with the risk-free rate will have to increase their capital contributions and/or revise the target outcome. Those who chose not to take any risk should be on track for their original outcome.
John Kenneth Galbraith, the economist and economic historian, held that “the only function of economic forecasting is to make astrology look respectable”. Many investors face earthly, rather than celestial, consequences arising from their investment choices. Consequently, would investors not be in a better position if encouraged to plan prudently, recognising gains when earned? Admittedly, the task ahead on such a basis is likely to appear daunting but is it not better to create realistic expectations upfront? Taking credit for gains before they are earned is analogous to spending potential lottery winnings after buying the ticket. Hitting the jackpot would be a welcome outcome but how many commit to, as opposed to dream about, spending plans before the draw? Why should investment plans be treated any differently?