In the realm of investments, a common question asked by many is, "how fast should my portfolio grow?" This query, while seemingly simple, is layered with complexities. To unravel this, one must consider market performance, risk tolerance, asset allocation, and a host of other factors.
Balancing Expectations: The Assumed Rate of Return
One of the crucial aspects to deliberate is the 'assumed rate of return' on an investment. This expectation could sway your investment strategy. Anticipating a too-high rate of return might inadvertently lead to under-investment, while a conservative approach could set you on a safer path towards your financial goals.
It's important to discern between an optimal rate of return and the one that offers the highest possibility of attaining your investment objectives. In an ideal situation, your portfolio would consistently yield a whopping 15-20% per annum. However, this isn't a realistic assumption.
Market Performance: The Unseen Hand
Investors who joined the market after the 2008 crash may have enjoyed a period of remarkable bullish market performance. This might lead to the assumption that such performance is the norm. Yet, the market, and not the investor or their advisor, sets the pace for potential earnings. Market trends over time generally show a "regression toward the mean," encompassing both bullish and bearish years, in a cycle of stock market corrections and retracements that align with a long-term average.
Hence, a continuous bullish run for a number of years should not set the standard for future expectations. Investors who have weathered the market for decades understand that there will be years of modest returns, and even bearish periods.
Long-term Returns: A Lesson in Modesty
Typically, the long-term return on investment averages closer to 8%, as opposed to the more ambitious 16%. Adopting a conservative stance on your investment assumptions could lead to a healthier portfolio in the long run. For instance, an investor might be tempted to presume their portfolio will grow at the same 10% rate the S&P 500 has achieved over a given timeframe. However, basing investment decisions on such assumptions could lead to underinvestment and a lack of compounding interest.
In case of more modest returns, the investor might realize, rather too late, that achieving their retirement goal has become significantly more challenging. They may need to invest an additional substantial sum per month to meet their goals—an often-unfeasible task. This could even lead to extended working years or part-time employment during retirement.
Safeguarding the Future: Conservative Assumptions
Many financial planners suggest using a more cautious assumed return of as low as 6%. This conservative strategy enhances the likelihood of the plan working as designed. If the portfolio then manages to outperform these modest expectations, achieving a long-term average rate of return over 10% or even 15%, it creates a pleasant surprise. This could mean an opportunity to retire earlier, travel more, or offer financial support to children or charity.
The pace at which your portfolio should grow depends on various factors such as market performance, risk tolerance, asset allocation, and your overall financial goals. While the allure of high returns is hard to resist, a more conservative approach may serve you better in the long run. Understanding these dynamics is critical to developing a robust and sustainable investment strategy.
Summary:
The assumed rate of return on an investment is an important consideration, especially since assuming a rate of return that is too high might cause the individual to under-invest..
In a perfect world, your portfolio would average 15-20% per year, forever, but this is really not feasible.
You might have experienced a bullish 7 years, for instance, but investors and advisors that have been in the market for 30 years or so have learned to be humble enough to accept very modest returns in years which are not as bullish, or even bearish.
Long-term return is generally closer to 8% rather than 16%, and being conservative with assumptions can only make you wealthier. If an investor assumes that their portfolio will earn 10%, since that is what it appears the S&P 500 earned over the last time frame the investor is looking at, the investor may calculate that he or she would only have to invest a small amount to reach their goals.
If the return is more modest than that, the investor may discover one day that it will be extremely hard to reach their previous retirement goal, because, after being underinvested, they no longer have the opportunity for as many years of compounding interest.
What Should I Compare the Performance of My Portfolio With?
How Often Do I Need to Rebalance My Portfolio?