You may have reasonable expectations of what you can expect from your investments during the coming years and decades. But regardless of what your risk-adjusted return expectations are, the first rule of economics cannot be denied: There is no free lunch.
I was reminded of this by a report that the League of California Cities wanted the state’s big public pension fund, CalPERS, to boost investment returns. However, I did a double-take when I read the following.
The legislative representative to the League of California Cities urged the CalPERS Investment Committee Monday to think “out of the box” in finding a way to exceed its 7% investment return projections, saying that cities won’t be able to pay their monthly contributions to the pension plan if returns are that low.
There is so much wrong with this statement, so much at odds with the body of knowledge investors have painfully amassed over decades, that my first reaction was that I must have misunderstood it.
Let’s take a deeper look at the error here and why the underlying thinking it reflects is one of the most dangerous attitudes any investor can have.
First, potential returns for any investor (institutional or otherwise) encompass a broad range of possible outcomes. We know what different asset classes have returned historically; this provides the baseline for what is probable, perhaps even likely. But there is always the possible outlier that surpasses the historical return ranges. While these are improbable, they are not impossible.
Second, future returns are directly correlated with how much risk an investor is willing to assume. Risk can be defined as the probability that actual returns on an investment will be lower than the expected returns. Take on more risk and you might generate more returns than the market — or, as so often occurs, produce less-than-market returns or even losses.
Those who declare that they want higher returns must also recognize that they are also implying a willingness to risk lower returns to get them. That is the very definition of risk. Pursuing alpha, or above-market returns, means you will occasionally forsake beta and matching the market. Any other way would mean a free lunch.
Next, there is execution risk. There is no guarantee your investment managers will adequately express the risk-reward ratio you want in pursuit of your goals. Note that this is the single biggest area that consultants and advocates should focus on; it is the one thing that is most within the control — and dependent upon the skill — of the money managers.
Finally, returns are driven by factors such as interest rates, corporate profits, inflation and valuations, to name but a few. Knowing this, investors must make probabilistic decisions using incomplete information about an unknowable future (see this and this). But of all the things returns are based upon, they are never dependent upon what you need or desire. Those issues are simply irrelevant to what markets will produce.