I know this may sound strange coming from an investment professional, but I have come to HATE rate of return discussions. The way that most companies present investment “rate of return” to their prospective clients is generally so over-simplified and remote in time as to border on the ridiculous, if not in fact fraudulent.
These are bold claims, but allow me just one example to demonstrate its veracity. I will set out the advice that you might receive from a fictional financial planner, Ed Jones, then you decide if the “rate of return” that he projects for you has any basis in reality.
To start, we have to imagine where Ed’s advice is going to lead you. In other words, what would your portfolio look like following Ed’s advice? I have a pretty good sense of this because I see these portfolios every day. More than likely your portfolio would consist of mutual funds (or stocks & bonds) in a qualified account (IRA, Roth IRA, 401(k), SEP, SIMPLE, etc). If Ed is a good guy, he will also have you set up a cash emergency fund in some sort of bank account (savings, money market, CD, etc). If you have any money left, Ed will make sure that all of your risks are managed through insurance. And that usually covers it.
Is there a benefit to this arrangement? Yes, of course. You get tax-deferral in your investments and, most often, tax deductibility. You have cash for any bumps in the road and your insurance will kick in if any major calamity (health or property) happens to you. So where’s the rub?
First, the client buys off on the proposal based upon very speculative projections of their investments growing at 6, 8 or 10% rates. Second, the client is never shown the COST of the decision to arrange their finances this way, which is akin to claiming that gross profit is the same as net profit. It is this second problem that I will focus on for the remainder of this article.
What Ed has failed to account for is where you will get the money to make your regular, major purchases (cars, home repairs, vacations, educational expenses for children, etc). In other words, since he has your cash flow allocated into locked boxes (especially the qualified accounts where you get penalties and taxes for early withdrawal), you have no capital for making major purchases. So that leaves you with one choice—borrowing—and that is exactly what Ed recommends.
In other words, when Ed was convincing you to invest in the market for better returns and locking your money into qualified accounts to avoid taxes, he never considered the COST OF FINANCING in his overall economic plan. And therein lies the mistake: Ed takes a micro-economic approach, looking strictly at rates of return and ignoring costs. But surely these costs are going to be a DRAG on your overall return.
Ed does this because he knows of no other way and assumes debt to be part of life. And truly debt is a part of life, which is precisely why he should try to MITIGATE its effects on your financial plan. He just doesn’t know how.
But to be fair and to make an accurate assessment of the REAL value of his plan, he ought to DEDUCT the amount of interest that you paid as a result of his advice. That would be the true NET return and a fairer estimate of the future value of your account. This would then allow a client to make apple-to-apple comparisons with other investment strategies.
And truly the STRATEGY is more important than the rate of return. When a prospective client comes to me and professes to be able to earn 10-12% long-term in the market, I know that I will have the near impossible task of convincing him to consider earning less but COSTING less and doing so on a GUARANTEED basis rather than in the very risky manner he proposes…and have people just forgotten the old adage that “what goes up, must come down?”
What I suggest will just be dismissed as “kooky” talk. I mean, who wants a 4% return, when they can get “12% long-term with stocks.” The demonstrable FACT that my real return will be significantly higher (and certain) and their market return significantly less (and at terrible risk) never crosses these people’s mind.
And that is just ONE reason (there are more) I hate the rates of return being bandied about these days. But perhaps now you can see why I HATE rate of return discussions.