I want 18% returns – is this achievable?

Traders Den

Yes, but you would need to be comfortable with possibly very bad performance for some years.

By Gustav Reinach

The biggest communication gap between advisors and investors is to fully explain what amount of risk needs to be taken in order to achieve specific returns.

Everyone wants the best returns the market can give, but what risk needs to be accepted to achieve these return goals?

When I started out my career building funds and later expanding to also give advice to investors about portfolio structuring, retirement planning and investments management I realised that very often investors have unfair expectations from their investment advisors to no fault of their own… TO NO FAULT OF THEIR OWN.

It is simply because returns of any kind can be generated, and this is told to the investor, but what is not fully explained is the risk that capital will be exposed to generate these returns. I came across a graph I honestly think explains this relationship between risk and return in the most profound way possible.

If this graph is understood correctly, expectations of returns will be transformed in the investment world.

*This graph shows different returns for different risk classes, measured from 1960 to the present. Source: Denker Capital

This graph explains two factors:

  1. To achieve average returns of a specific percentage in a portfolio, what drawdown an investor will need to be able to stomach in bad market conditions to achieve the return goal in mind.
  2. What a significant difference “time in the market” makes to an investment taking a certain amount of risk.

How to read this graph:

  • As seen on the top left of the graph, the orange line represents that this portfolio is invested in pure equities.
  • For this example, I will explain how to achieve the highest return profile on this graph (the orange horizontal line) which is between 18%-20% average returns (shown on the Y-axis).
  • Focus on the black dot on the orange line. This dot works with the X-axis that shows the “lowest return”.
  • As the graph states, the black dot shows the “1-year” returns.
  • In other words, the black dot on the orange line shows that the lowest return measured for one year in this portfolio was around -48%.

This means, as an investor that wants an advisor to achieve between 18%-20% average returns, the investor will have to face the fact that there is a possibility that the portfolio can fall 48% in one year (in terrible market conditions).

Now, this is where things get interesting. Let’s look at the blue dot on the orange line. The blue dot represents the five-year lowest return this portfolio has measured from 1960 to the present.

Notice that this portfolio still had the potential to achieve an 18%-20% average, and the blue dot shows that the lowest return this portfolio had produced over a five-year period was 1%.

This means that if invested in pure equities, it had the potential to achieve average returns of 18%-20%, but even if invested in the worst possible time of market conditions, the investor did not see a capital loss over a five-year period.

If we look at the orange dot on the orange line, it shows that the average returns are still 18%, but the lowest return was around 5%.

So, just to take things back to the beginning and explain this in layman’s terms:

  1. If you want to achieve 18% returns but cannot stomach a drawdown of 48% over a one-year period, it cannot be expected of the advisor to achieve these returns.
  2. Investors who want the potential to achieve 18% returns and who know that they can leave the investment for five years have a high conviction that there would not be a capital loss in the portfolio.

The most important aspect this graph illustrates, is the longer investors remain invested the less chance there is for a capital loss. A high-risk investment with great potential returns cannot be measured over a one-year period.

So yes, an advisor can achieve any returns investors would want in a portfolio, but the higher the return expectation, the more time the advisor would need, and the more comfortable the investor would have to be with possibly very bad performance for some years.

For more information about investing wisely, you can contact Gustav Reinach.

Phone: + 27 12 347 8240  | Mobile: + 27 83 267 5329  | Email: Gustav@brenthurstwealth.co.za