Expected Return of Portfolio: How to Discuss with Investors

“What’s ‘normal’ for my portfolio?”

There’s a gap between what the average investor expects from their portfolio and what their financial advisors think they should be getting.

How big is that gap? Probably larger than you’re comfortable with.

According to one recent survey, high-net-worth investors expect a portfolio return of nearly 18% —seriously!

In contrast, financial advisors expect portfolio returns to be closer to 7% on average. That nearly 11% expectation difference is a big deal, and if you aren’t prepared to have conversations with clients about how to accurately set expectations, you may need to prepare yourself for a lot of uncomfortable conversations instead.

Advisors have always had to hedge against misaligned investor expectations, but as the stock market climbs higher and higher (and they see crypto assets with percentage returns in the millions), those expectations can easily become impossible to manage. But in an almost unintuitive turn, talking about the percentage numbers of what returns to expect isn’t the best way to manage expectations.

Why Talking about Portfolio Returns Doesn’t Help Manage Expectations

Warren Buffet once described investor performance and decision-making like this: “Stocks are the only thing consumers refuse to buy when they’re at their cheapest and only want to buy when they’re at their most expensive.”

In other words, investing behavior itself often leads to poor performance and misaligned expectations. Perfectly timing the market is impossible, even though much of financial media makes it sound attractive to investors.

Instead, investors see the market rising, fear missing out, and put money in to try to take advantage. In many peoples’ minds, their portfolio should do exactly what the S&P 500 is doing (which is why they think their portfolio should get 18% in a year right now).

But investing doesn’t work that way. In a bear market, investors are laser-focused on the fear that they may be taking on too much downside risk. And it’s those very same investors who are left wondering why their portfolios aren’t performing as well as the S&P 500 in a bull market. If there’s one question that has driven advisors insane, it’s this one: “Why is the market beating my portfolio?”

An unfortunate number of investors might land on the answer being that their advisor simply isn’t good at managing their money—but the answer is more likely that they don’t understand that their expected return of portfolio isn’t about numbers.

And trying to set expectations using a specific number becomes a lose-lose situation. For many advisors, it doesn’t matter how many qualifiers or context they add to a conversation, an investor is likely to only remember one thing: The number they set for a portfolio’s expected return.

If returns are below the target set by an advisor, investors won’t be happy. And even if returns are above that target, investors still might not be happy if the overall market looks like it’s going even higher.

So just like that, setting an average return expectation leads to bad expectations and sets up advisors and their clients for failure. It’s a situation that’s difficult to overcome for even the best advisors.

So what’s an advisor to do?

Understanding the Expected Return of a Portfolio Begins with Quantifying Risk

Investors don’t like losing money (hello, obvious). They also don’t like volatile markets—and they actually say that they would prefer to be safe instead of too risky. That sentiment is shared by 79% of millennial investors.

But when the market soars, FOMO can creep in.

By talking about risk first instead of portfolio performance, advisors can help their clients to manage that FOMO and stick to their long-term plans instead of jumping ship.

Quantifying risk alignment from the start sets clear expectations built on informed decisions. Knowing exactly how much risk is in a portfolio helps the conversation center on standards of predictability, rather than a static performance number.

For example, with risk as the focus, you can explain how fluctuations in the market still fit within the guidelines of an investor’s risk profile—and 95% of the time, they’ll fit. Suddenly, helping investors understand the ways a portfolio can behave gives them permission to hang in and stick to the plan, even if markets get volatile.

Putting risk first in conversations establishes for key mindset shifts for your clients when it comes to how they think about investing and themselves:

1. It removes stereotypes.
All too often, investors get lumped into generalities because of their age. A young person is “aggressive,” while a retiree is “moderately conservative,” whatever that means. In truth, people and their goals aren’t that simple. Putting quantitative risk first moves past stereotypes so each client’s expectations can be created based on their own unique plan.

2. It limits overwhelming feelings.
We live in a 24/7 world where information never stops. Your clients are bombarded with opinion pieces on the markets wherever they turn, but all that information can be irrelevant to their actual needs. When investors have the right expectations explained to them, they can easily tell when information is relevant to them so they don’t have to listen to every voice they hear.

3. It addresses the short-term fears that sabotage long-term outcomes.
Bad expectations come about because, at times, investors make short-term decisions when they should be operating with a long-term mindset. Last week’s performance doesn’t matter a whole lot when clients know that they need to be invested for 30 years, not 30 days.

4. It sets the right expectations.
When investors get clear about what’s normal for their unique portfolio, they can be fearless when it seems like everyone else is panicking. Clear expectations, with quantitative risk at the center, set the stage for long-term investing that gets investors to where they want to be.

Setting the right expectations begins with the right communication, and the right communication begins with helping clients understand the role of risk. It’s not about getting clients to agree to a particular number. Instead it’s helping them see that 95% of the time, their investments should fall within a certain range—and the other 5% are events that can’t be quantified, but when those rare events do come up, that’s when actions that need to happen, will happen.

At this point, investors get a simple and clear understanding of their portfolio and how it should behave. And they can give advisors the most important thing you can ask for: Buy in and a belief that they’re on the right track.

So, start the conversation with risk, not returns. It’ll set the right expectations from the start and empower clients to invest fearlessly for the long haul. Want to hear how that client conversation goes? Check out this video to hear it in action. With Nitrogen, you can also leverage Detailed Portfolio Statistics to build the perfect portfolio and help clients make the best investment decisions.