Risk adjusted return
March 28, 2013
Today’s column is about an imaginary Oakville couple in their 50s who want to start planning for retirement. Now that the children are off to university it is time to focus on their golden years.
They interview three investment advisors who outline their investment strategy. The investment return projections range from low, medium to high; five, seven and nine percent per year.
Which advisor should they choose? If this was you, who would you pick?
We will assume all factors are equal, you like them all, you are confident in their abilities and you could see yourself working with any one of them.
The temptation is to choose the advisor who presented the highest projected investment return of nine percent. It may seem logical but from an investing perspective it may be the wrong choice.
The theory and practice of investing is not to maximize investment returns but to minimize investment risk. Once risk is minimized, then within that context you want to maximize the return but only with that same level of risk.
Why take risk that you do not need. The industry term for this is a risk-adjusted return. The key is the subtle blending of the desired return within the risk level which you are comfortable. Try to get the best return with the least amount of risk.
Investment portfolios should be designed to achieve a specific target return. This requires some planning and a little number crunching.
The planning is a collection of all the important variables such as how much money you have, how many years until retirement and how much can you save every year while you continue to work.
Looking forward you will estimate your spending needs in retirement and then determine from where that money will come. Funds will flow from government benefits such as the Canada Pension Plan and Old Age Security. Perhaps you are fortunate to have a pension from your employer. The balance will come from savings.
Working backwards you determine how much money you will need at your retirement age to provide the necessary annual cash flow.
A part of that process is determining the target investment return you need to achieve the desired amount of money. With sufficient assets and less spending you can accept a low target investment return rate.
Simply put, you can reduce investment risk and still achieve your financial objectives. Yes a higher return would be nice but why risk more than you have to when increased risk can increase the chance of disappointing investment returns.
The key is not the high return potential. The key is managing and reducing your investment risks which means your desired return is more constant and with less risk of failure.
Consider our couple. They would be delighted if they earned more from their investments. However, if they took additional risk to earn extra money they did not need, how would they feel if those risks caused them to miss their target return and therefore, not allow them to have the secure and comfortable retirement they planned.
When you hear of good investment opportunities put those opportunities in the context of your investment objectives and investment target returns. You are not looking for a great return. You want the necessary return that allows you to be comfortable, safe and able to enjoy your retirement years.
Bottom line is that investing is more about you and what you want to achieve. Managing the risk is what is most important.