Setting Investment Goals ProperlyThrough the Use of Science and Art

When developing optimum investment plans for individual families, non-profit organizations, retirement plans and similar clients, one must recognize the murky junction of mathematics and art, or if you will, comfort.

The key to properly setting realistic investment goals is coming to grips with the uncertain future. Gains from most investment portfolios are not the sole goal of the portfolio, but rather as a source of future spending. At the end of the primary investment period, which could be as short as a month or as long as a grantors’ life, there is a desired minimum spending plan. To fund the spending, a minimum capital level needs to be in place. To reach the capital goal compared with today’s resources and future net contributions, if any, a calculation to the rate of capital growth is needed. For example, take the selection of a desired minimum annual return, 4%, 8%, 12%, 16%., etc. The critical question that remains is, how quickly can the capital base for the spending be put into place? There is a helpful tool available. An old arithmetic “rule” holds that the number of years needed to double your money is to divide the rate into 72. Thus at a 4% rate, it would take 18 years (which might be acceptable for an early college savings plan or a conservative after-tax and inflation retirement plan). An 8% return (a rate many retirement plans used prior to 2008) would produce the capital required in only 9 years. In the past, after prolonged market declines, 12%-16% gains have been achieved, reaching their mathematical goals unadjusted for taxes and most importantly, inflation, in 6 and 4 ½ years respectively.

I have set a trap for the naïve investor and/or administrator who focus only on the rates of return as shown above. There are at least two other factors that need to be considered. The first is an understanding of the importance of the impacts of terminal dates. In the examples briefly described above, one can see that to some degree, the rate of return is heavily influenced by the starting point. In a market that has a long-term secular upward bias (as has been the case for all of our lives), the lower the market level for stocks and higher the level for interest rates, the more likely investment performance will be good.

Relatively little has been written about the nature of the investment markets at the end of a particular period. I have not seen anything on the probability that, after a period of achieved good performance, poorer performance should be expected from the same portfolio. No one has suggested that if you get 16% over a five or ten year period, go to cash. I do remember one sagacious pension plan that immediately went to 100% cash when they were up 20% in any single year. While the fund had a good year-by-year record, if the 20% gain was achieved early in a year of spectacular gains, it missed out in getting the balance of the gains sufficient to provide a good record in the long run. Considering the operational and financial leverage that is built into the system, a double digit investment record in a period of single digit economic growth will lead to an over-valuation; one should expect periodic declines after periods of large gains.

One can not express often enough that following a high performance period, one is likely to see a market decline or give-back. As if awareness of future declines is not difficult enough, remember that most investment pools are not entirely or even mostly, date dependent. In rare cases, capital pools are used only to meet a specific date obligation, e.g. pay off a bond/mortgage or pay for a new building all at once. When obligations are specific and/or date-defined, a separate portfolio with its own portfolio and investment strategy may be advisable. (See my blog for August 2, 2009).

For the moment go to other extreme and think about the spending rates needed to support an entire family on a multiple generation basis, or an endowment to provide meaningful scholarships and fellowships. There is no terminal date for this portfolio until the money runs out. In this case, relative performance may become important. One investment strategy would be to attempt to keep performance rankings in the middle three quintiles, avoiding too heavy a weight in the lower of the three.

In addition to terminal dates, the second factor that needs to be considered is comfort. The biggest single comfort factor for many is to stay within the bounds of prudence as established by others. This is a concept of being outwardly directed. (Better to go down with others than to rise individually.) Going down is the in the domain of comfort, or more specifically, discomfort. In using an absolute performance filter, the bounces taken along the trajectory of success become very important regardless of expected terminal results. Academics and consultants have developed the use of “Beta” which is a measure of volatility, but has also become critical in providing comfort to nervous investors. There are lots of things wrong with this concept, particularly issues regarding its predictability, the differences between upside and downside beta, and most importantly the choice of the optimum investment vehicle. A valid concern of relying on Beta is that investors will be shepherded into making choices with fewer recorded bounces, reducing the odds of participating with successful managers who make frequent right choices.

When using relative performance and performance ranking within in a universe of peers, the selection of the appropriate peers becomes critical. This task requires a continuous effort to ensure that similar strategies, commitments, fees/expenses and other vital requirements are sufficiently similar. The “comfort factor” also includes numerous soft items, including name recognition and reputation of the manager, availability of the portfolio manager for in-depth conversations, ease of administration among others.

Investors spend too little time thinking about their investment objective settings. For most, there is attention focused on these issues at the beginning of the account and/or a significant change in advisor, consultant or important members of an investment committee. When conditions change, a review is often conducted. Under these circumstances, changes that are made are often reactive, based on extrapolation of the existing conditions rather than forward looking.

Please feel free to comment or to ask me a question on investment goal setting. Click “comments” below this entry, or send me an email reply.