How Much Should a Portfolio Earn?

Are you getting enough return on your investments?

Portfolio return expectations differ because a portfolio’s performance depends on its composition, which is based on an investor’s goals, timeframe, resources, and skill and risk tolerance levels. These parameters must be balanced against each other, with reciprocal tradeoffs: For example, the higher the return expectations, the more risk an investor has to take, while short-term goals limit the types of investments that may be used. You may use a number of benchmarks to set realistic portfolio-return expectations.

Total Return

The term “earn” may be misleading. An investor makes money through investment income, such as dividends and interest, and capital appreciation, which is an increase in the price of an asset. Earnings, or earned income, is cash in the pocket, but capital gains, on the other hand, aren't certain until realized — that is, until an asset is sold. A portfolio of growth stocks may earn just 1 percent in dividends while appreciating 20 percent annually. Total return is more useful in evaluating performance because it combines investment income and capital appreciation. A bond portfolio may earn 4 percent in annual interest but lose 10 percent in value, producing a negative total return of 6 percent.

Risk-Free Return

It's useful to compare potential returns to risk-free returns. An investor has to take risks only when he can't achieve his goals any other way. Returns from federally insured bank products and short-term Treasury bills are considered risk-free. An investment that involves risk should offer a higher potential return than a risk-free investment to justify the risk.

Capital Preservation

An investor’s first goal is capital preservation. A portfolio strategy is useless if an investor loses his capital because she won't have the means to implement it. Investors who lose the least quite often do the best in the long run. It's therefore more important to have a loss limit for the worst-case scenario when setting return expectations.

Realistic Expectations

Potential return expectations should be greater than the loss limits to justify investment risks. Historical returns for different asset classes may serve as a base for setting return expectations. For instance, if stocks have on average returned 10 percent annually over the past 10 years, it would be reasonable to expect the 10 percent annual return to continue. But even this approach has its flaws, because investment prices move in trends. Once it reverses, a trend may continue in a new direction for several years, which is why most investments have a disclaimer that past performance doesn't guarantee future results. Stocks may decline 10 percent annually for three years in a row, then reverse and advance 15 percent annually for the next three years.

Absolute Returns vs. Benchmarking

Absolute returns compare a portfolio’s balance at the beginning and end of a period. Investment portfolios are often benchmarked— that is, designed to approximate various unmanaged indexes. Benchmarking is useful because it can give you a baseline, but it can also be used as an excuse for poor performance: For instance, if an unmanaged index is down 20 percent, a portfolio benchmarked to that index may be said to have “outperformed” the benchmark by losing “only” 15 percent.

References

• FINRA: Building Your Portfolio
• FINRA: Evaluating Performance
• “A Random Walk Down Wall Street”; Burton G. Malkiel; 2007