In my last job with a large investment bank I built two global research teams and worked with high-profile clients around the globe. Having left the big leagues to start my own firm, my clients are more diverse in terms of wealth. While I still work with some high-flyers, I mostly work with the mass affluent or millionaire-next-door types (but also some less fortunate families). To convey my previous experience when meeting new prospects, I would sometimes say “I used to work with billionaires, but now I work with millionaires.” Then someone asked me what I did to them…Humor aside, my experience has helped me understand the varying degrees of desire and need for returns among different types of investors. All else equal, virtually everyone prefers higher rather than lower returns. However, the prudence of pursuing higher returns depends on the financial situation and goals of each individual or organization.

This article focuses on the relevance of returns for four types of investors:

  • Those saving for retirement
  • Those with just enough to retire
  • Those likely to leave behind a significant estate (for heirs, charities, etc.)
  • Those with multi-generational goals for substantial wealth.

For each investor type, I consider how relevant higher returns are to achieving their goals and the role their preferences may play by potentially imposing additional constraints.

On balance, I’ve found that the demand for higher returns generally increases with the magnitude of wealth.This is due to two primary factors: 1) an increased capacity to assume risk and 2) an increased capability to invest for the ultra-long term. I discuss the nature of this trend across the wealth spectrum. In the case of substantial wealth, I quantify the need for returns and present a model for analyzing multi-generational investment goals. This provides a sensible and intuitive framework for assessing their investment strategies. My model indicates multigenerational wealth effectively needs to pursue higher returns via higher equity allocations in order to accommodate familial growth and combat inflation.

Figure 1: Factors Related to Pursuing Higher Returns

Returns

Source: Aaron Brask Capital

Overview

There are two key ingredients for most investment-related marketing pitches: return and risk. Some advisors will tout the performance of a particular investment. Others will focus on the conservative or low-risk nature of an investment – perhaps even guaranteed returns(1) All else equal, higher returns and less risk sound great. However, it is critical for investors to understand the importance of returns and risk in the context of their broader goals (as well as the certainty of the fees) involved in pursuing various strategies. These considerations can impact many decisions around the investment process including:

  • Advisor engagement (if any): Type of advisor, services, compensation structure, etc.
  • Financial plan and investment strategy: Asset allocation, source of retirement income, etc.
  • Choice of actual investments: Funds, individual securities, active or passive, etc.
  • Performance and cost: All of the above will impact overall performance and costs.

This article addresses the relevance of higher returns for different investors and is organized in two parts. Part I contains three sections discussing several factors involved in balancing risk and returns. The first section focuses on two key components of risk that can determine one’s success or failure in achieving their goals. The second section highlights three primary strategies for achieving higher returns. The third section discusses the concept of need versus preference when it comes to returns.

Part II contains four sections – one for each investor type. Based on the perspectives highlighted in Part I, I discuss the relevance and risks associated with pursuing higher returns for each type of investor.

Part I: Risk and Returns

1 – Dimensions of Risk

At the broadest level, I think of risk as anything that can result in one’s failure to establish and achieve reasonable goals. In the context of investments for individuals or families, these goals typically relate to their retirement, standard of living, and objectives related to their legacy (e.g., heirs and charitable causes). Given the importance of and widespread need for retirement planning, this will be the default focal point (unless otherwise stated) of this article.

I divide risk into two primary components: strategic and investment risk. Strategic risk involves the setting of realistic goals. In order to set realistic goals, one must estimate both the income required to support one’s goals as well as investment returns(2) for various types of assets (e.g., stocks and bonds) over a typically longer term horizon (e.g., 30 years). Given the uncertainty around future spending and market returns, it is naturally important to pursue a conservative approach in both these endeavors.

Figure 2: Decomposing Risk

Returns

Source: Aaron Brask Capital

One facet of strategic risk relates to the investor’s risk profile. For example, some investors simply cannot tolerate much volatility. Accordingly, financial plans involving heavy equity allocations or insufficient allocations to less or negatively correlated assets (e.g., hedge funds) can make the investors so uncomfortable they abandon the strategy at an inopportune time (i.e., sell stocks after a period of volatility where prices have fallen significantly). A similar argument can be put forth for tracking error. If, for example, the S&P 500 has gone up by 10% but their value-based portfolio was flat or down, then an investor may feel left out of the market’s gains and want to jump ship.

The second component of risk relates to investment risk. Once one has crafted a realistic plan or strategy and identified the guidelines for their allocations to various asset classes, one must execute the investment strategy. This typically translates into selecting managers and products (e.g., investment funds) to fulfil the plan’s allocations. Assuming the return forecasts were reasonable, investment risk surfaces when a manager or product deviates significantly from their benchmark.

For example, an equity fund manager pursuing a value strategy might fall in love with some particular investments and drift into a growth strategy (in order to hang on to those stocks that are no longer value-oriented). This style drift can have an adverse impact on the overall financial plan by changing the overall asset allocation. Given that each plan is based on varying degrees of diversification, an unexpected concentration in a particular asset class, sector, or style can introduce additional risk and jeopardize the original goals.

On balance, different investments lead to different results. It is important to align the investments with the needs and preferences of investors. A significant part of this involves management of expectations. Regardless of the risks one is taking, (e.g., stocks, bonds, growth, international, etc.), it is a good idea to make sure investors are comfortable with the overall level of anticipated volatility and/or tracking error so market performance will not catch them off-guard and make them question their strategy.

A Word on Fees and Taxes

I do not delve into the issue of fees as they are a certainty, not a risk. In my view, the real risk with fees is whether a particular investment or product provides performance commensurate with the fees. Many strategies have been commoditized and are available in low-fee index funds. So it is important to weigh how likely more expensive funds will outperform a similar fund with lower fees.

Note: Many

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