The first adjective refers to their risk tolerance over a short period of time (i.e., less than five years) while the second refers to a longer period of time (i.e., greater than five years). The second column, “Projected Total Return,” is our estimate of the total return for each portfolio for the next 10 to 20 years, assuming that inflation is 3%. Since returns don’t come nice and even, the next column provides the range of returns we expect most of the time (our euphemism for one standard deviation.) Finally, the last column is an indication of how bad it might be if we have a really rotten year. We use quotes around the descriptor “worst case” (our user-friendly term for two standard deviations) because it only reflects 90% out of 100 years. There is a slim chance that it could be even worse than that.
I tell the clients that if they feel they are really “conservative,” we can design a portfolio with a 6% return where most of the time the portfolio would break even. In a really rotten year, perhaps the “worst case” would be minus 4%. On the other hand, if that return seems too low, we might design for a positive 8.6% total return for the year, but the “worst case” may be minus 20%. I make it clear that this is a one-year estimated loss, not the loss reflected on the day after a crash. Then to remind them that really bad times happen, I point out what happened to the portfolio during the grand recession. We then have a lively discussion about the relationship between risk and return, resulting in the client “selecting” a portfolio that best reflects his balance between risk and return.
Illustrative Tools For Synthesizing Concepts
August 3, 2015
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