1. Money
Dana Anspach

Wouldn’t You Be Leery If Your Doctor Said…

By February 19, 2013

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"This drug can fix you with no negative side effects."

Or are you the kind of person who would say "Ok, sounds great!"

Or maybe you'd get a second opinion. What if the second doctor said "Yes, that drug might have some positive effects, but realistically, here is what you should expect, and here are a few alternatives."

Now what do you do? Go with the first doctor who promised everything would be just fine, or go with the second doctor who presented things more objectively and offered alternatives? What if it was your life on the line; does that change your answer?

I encounter this scenario frequently with investment management services. Someone calls or emails me, and says, "This investment management firm said they can get me 8.5% returns. What do you think?"

Here is what I think. Suppose you are expecting stocks to average about an 8% return over the next 10 years. And realistically you think bonds will average about 4%. You build a portfolio that is 60% stocks and 40% bonds. What returns might you expect?

.60 x 8 = 4.8 (60% of your portfolio is earning 8% so it is contributing 4.8% to the total return)
.40 x 4 = 1.6 (40% of your portfolio is earning 4% so it is contributing 1.6% to the total return)

Total return 6.4%.

Now that is a gross return, and so you have to subtract out some investment fees. Suppose those are 1%. The expected return net of fees then goes to 5.4%.

So in order to earn 8.5% what do the assumptions need to be? Basically you'd have to assume that you have 100% stock portfolio and that stocks are going to average at least 9.5% a year. Over the long run (80 plus years) stocks have averaged about that, but will they over the next decade? Maybe, maybe not. And even if they do, will it be without volatility? Certainly not.

Now once, upon explaining the math above, I had someone write to me and say, "Well you told me you could only get me 6% returns."

Huh? No I didn't. I explained reality to you.

When it comes to investing, everyone wants to believe in fairy tales. I love fairy tales, and I love Disney movies too - but I wouldn't base my retirement security on their story line.

If you are curious to see how markets have performed over various time frames see:

August 7, 2013 at 1:40 pm
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