According to a 2016 McKinsey report, investors may need to start lowering their expectations due to anticipated diminished returns. So, what to do? Spend less?
That doesn’t sound very fun to me! And if you’re human, it’s difficult to implement an effective strategy to reduce spending. Elin Helander is a cognitive scientist at Dreams in Stockholm. She explains:
“I know myself. I knew that I would have to set up some sort of a structure to separate my spending from my savings. This mental accounting is critical because otherwise if I have the opportunity to do something I will always choose to take it. My brain has a way of rationalising reasons to spend money: “Don’t I need a new bag? Yes, I do need a new bag. It’s a good deal. My old one is too small…”
Here’s my advice:
#1 Get to know the fine details of your overall financial situation.
Your investment portfolio is only one piece of a much larger puzzle.
I worked for over 20 years as a portfolio manager advising high-net-worth clients, and I can tell you that fewer than 10% had spent the time and energy on a professionally prepared financial plan. Why not?
Part of the problem in our industry is that it’s still very difficult for people to find unbiased financial planning advice. Most planners are associated with banks or mutual fund firms and they are paid (either directly or indirectly) to sell investment products. These financial plans often look suspiciously alike and they usually don’t go into the necessary amount of detail.
I recommend taking the time to find an independent financial planner with a strong reputation. She will be worth her weight in gold.
Rona Birenbaum founded Toronto’s Caring for Clients – a fee-based financial planning firm. I spoke with Birenbaum about today’s concerns about return expectations and her approach to financial planning:
“It’s a timely topic because it is a common heuristic to assume that future returns will be similar to the most recent past, whether positive or negative. In the late 1990s I was seeing financial planners using 8 and 10 percent return assumptions in long-term retirement plans. They were looking at the previous 10 year market returns and extrapolating. Very dangerous. The following 20 years were terrible for equities and those who made saving decisions and spending decisions on an overly optimistic plan assumption paid dearly. When other planners were using 8 and 10 percent assumptions I was using 5 and 6 percent assumptions and these days I use 4% as my return input. Sometimes I have to make a case as to why the assumption is conservative but once I do clients understand and appreciate the approach.”
#2 Be open-minded to alternative asset classes
Consider allocating up to 20-30% of your investment portfolio to alternative asset classes such as private equity, commodities, real estate or something that resonates with you personally such as a gender equality fund.
Take the time to do your research so that you feel comfortable with the risk/return profile of each alternative. Adding non-traditional asset classes will not necessarily lead to better performance depending on the mix selected, but this strategy is likely to provide a smoother ride (lower risk or lower volatility) for investors. As outlined in this Goldman Sachs report, diversifying into alternative investments can offer similar potential returns with lower risk.
#3 Reduce your expectations and don’t chase returns!
When the expected return drops, some people think to themselves “I don’t want to make 5% returns, I still want to make 10%” and they promptly rush out and buy products that seem to offer higher returns. In my experience, this is an unwise approach. These seemingly attractive products don’t usually end up producing higher returns: instead they are almost always riskier and lead to worse financial outcomes.
A much safer strategy would be to accept the reality of the current investing environment. Stop thinking about the way things used to be. Are 5% returns really so bad? Let’s look at an example.
If you invest $250,000 today and it produces an average annual return of 5%, in 10 years time you will have $407,224 and in 20 years time you will have $663,324. That is assuming you let it compound, and never take any money out.
The bottom line on how to handle lower future returns? Build reasonable expectations into your detailed financial plan. Then stick to the plan and don’t worry, be happy!