Financial Planning: What Return?

What return on your investments is good?

Modern Portfolio Selection is about allocating your assets (investments) to get the return you require at the minimum risk. If you don't know what return you need then you are an investor without a compass. You may be measuring your investment success against the gain in the S&P500, the Russel2000, or some other benchmark. Your investments might be driven by calls from brokers who want to help you "beat the market" - and with every trade you make they get a commission. A good test question for your financial investing savvy is, "In fifteen words or less explain why you would structure your investments to purposely under-perform the S&P500." If that question seems crazy to you, then you are a imprecise investor.

The precision investor, on the other hand, knows the return that they require to make their financial plan come true. Ted knows that he needs a 7% return on his investments - significantly below the historical market return. Bob knows he needs a 23% return to make it work - way, way above what the market returns have been. Sally knows that 13% makes her clock tick. Each of these precision investors will allocate their assets differently to get the return they need with a minimum of risk. Bob is going to have to take some big risks and will need some luck to make his plan work; Ted's 7% is a shoo-in. If you're a Bob who needs 23% and you feel good about beating the S&P500 by 3%, you ain't goin' to make it.

(The answer to the question above? I don't want to take any more risk than is necessary to meet my goals.)

What return do you need? Let's find out.

How much do you have?

The starting point for your calculations is what you have today. Count up all your assets. That 401k, those bonds from Aunt Millie (get real), the cash you would get from the company retirement plan if you quit today, the value of your house, your credit union account, those company options that are vested today - what are they really worth?

How much do you owe? Count up credit card bills, the house mortgage, school loans, personal loans - all those encumbrances you have assumed.

Subtract the two, and that's how much you have. Quicken users can click on the "net worth" button and get this all in the blink of an eye.

Write down your net worth: ________________

How much do you save?

The interesting thing about retirement planning is that the more you save early in your life, the more it counts - Einstein called it "the miracle of compound interest." On the other hand, how much you save in the last five years before you retire counts for almost nothing. To complete these calculations you have to write down how much money you put into retirement savings each year. Don't count the money you save to go on vacation, buy a new car, etc. Do include your 401K contribution, your stock purchase plan, your company's contribution to your retirement fund.

Write down how much you save each year: _________________

What return?

For Ted's simple sample case he needs $500,000 at age 65. Ted is 40 and his total net worth is already $300,000 (that 401K he started when he was 25 really added up!). He saves $10,000 a year in all his various plans. This year Ted's net worth will grow by the return he earns on the $300,000 and the $10,000 he will save.

If Ted's portfolio manages to get his target 7%, at the end of this year Ted will be worth ((300,000*0.07) + 10,000) = $331,000. At the end of next year Ted will have a net worth of about ((331,000*0.07) + 10,000) = $364,000. I think you can see that if he continues this way for 10 years Ted will have quite a nest egg on his hands.

Let's say Ted is 40, has a net worth of $300,000 and wants to down shift at age 47 with $500,000 in the bank. If Ted continues to contribute $10,000 each year to his savings, what rate of return will Ted need to achieve? 4%. Can you believe it? Only 4% and Ted gets to make his financial plans come true!

If you have a spreadsheet and a simple set of goals you can do the calculation yourself. The table below gives you an idea of the calculations.

Year 1 Year 2
Beginning of year Net Worth A1 A2 = YE1
Return (b%) A1 * b% A2 * b%
Contribution C1 C2
Year End Net Worth YE1 = A1 + (A1*b%) + C1 YE2 = A2 + (A2*b%) + C2

When you have Year 1 (today's age) through your Retirement Year filled in, the rest is easy. Initialize A1 to your current net worth. Put in a proposed b%, start with 5%. Now, how much do you have when you retire? What year does your net worth hit your nest egg amount? That's the year you can retire. Why not bump up the return to 7% and give that a try? How much sooner can you retire? Or reduce the return to 2% and see if this really safe return rate meets your goal.

Many of the people I've talked with have not taken a hard look at their financial plan. They have their 401k invested in a bond fund or totally invested in a small cap fund. Either of these could be the right plan for them, but they have done their investing blindly. (Some people even have it all in a one-stock fund; I can't imagine why this would ever be a good idea.)

If you need a 4% return to make your plan work, then you should not invest to "beat the market." If you need a 23% return to make your plan work, then you better be investing to beat the market (any praying). Step 4 discusses how to invest to get the return you need.

Step 4: Modern Portfolio Selection

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