Become a better investor by setting proper expectations

June 28, 2023 | GuidePost

Today, we want to talk about something that tends to “fly under the radar” in many conversations about investing: the importance of setting proper expectations.

Note: This video was originally published in our monthly client e-newsletter, Guidepost.

The importance of proper expectations

Today, I’d like to talk about something that seldom gets much attention when it comes to investing. In fact, it’s something that can profoundly impact how we experience virtually every aspect of our daily lives, from our relationships with family and friends to our business interactions and even to our vacation and holiday plans!

I’m talking, of course, about expectations.

You know, those sometimes pesky ideas we have about what something should be.

When it comes to investing, having proper expectations is a powerful tool in our arsenal to help us navigate the market’s inevitable ups and downs. In fact, setting realistic expectations is so important to achieving good investment outcomes that it is one of our core investment principles here at LifeGuide.

Why am I bringing this up today?

Well, because a lot has happened in the markets over the past few months. The government resolved the debt limit standoff, inflation continues to cool, and the Fed has finally paused its rate hikes for the first time in over a year.

Because of this, we are glad to see that the stock market is continuing its upward momentum. And yet, with all this positive news, those pesky expectations can sneak up and bite us if we’re not careful.

Here’s what I mean.

With stocks doing so well year-to-date, it’s easy to form wrong expectations about how your portfolio should be performing. This is because other categories of investments may be in your portfolio that aren’t faring as well—namely bond and real estate investments.

Bond and real estate investments are not doing as well because they are both sensitive to interest rates. And, as you may remember, the Fed has raised interest rates at the fastest pace since the 1980s.*

Let me say that again: Last year, the Fed raised rates faster than it ever has in recent history.

And the result? 2022 set a record for the worst performance year ever for US bonds.

How unrealistic expectations can set in

Let me lay out how we can easily develop unrealistic expectations in times like this.

You see, the news outlets have their favorite market indices that they tend to report on. The DOW is the most popular, but you will see the S&P 500 and Nasdaq as well. These are all indices that represent larger US stocks.

Given this, it is understandable that people often expect their portfolio to be performing like the DOW or the S&P 500 that they hear about so often.

But large US stocks are not the only markets represented in many people’s investment portfolios. International developed country stocks, emerging country stocks, bonds, real estate, small company stocks, and commodities are other markets that can be represented in your portfolio. Because these other markets are all represented by other indices you hear much less about, it’s often difficult to incorporate their performance into your expectations.

The performance of a well-diversified portfolio (one that contains far more investment types than just large US stocks) won’t and shouldn’t match large US stock returns.

Your actual return will be the average return of all investments contained in your portfolio.

So, in reality, your return will neither be as high as your best-performing asset class nor as low as your worst-performing asset class.

To illustrate further, I’ll use an example.For the sake of simplicity, let’s say your account is invested equally in three different mutual funds.

The first had a good year and was up 10%.
The second was up at a more modest 3%.
The last had a down year, losing 1%.

Your overall account performance would be 4%—the weighted average of the three returns.

So lower than the 10% return of the best holding, but much better than the 1% loss that occurred in the worst. Yet if all you heard about in the news was how well the first investment was doing (the one that went up 10%), it would be difficult to expect that your account should only be up 4%.

Setting realistic expectations for long-term success

Now, it would be great if a single asset class would consistently outperform the others or if we could accurately predict the winner each year. But the reality is there is not one type of investment that always wins. Reliably predicting short-term market winners and losers over time has been proven nearly impossible.

And what’s worse, playing this game and getting it wrong can have a devastating impact on your portfolio.

This is why we believe taking a principled investment approach based on meaningful diversification and guided by a comprehensive Financial LifePlan is the wise strategy for long-term success. And it always has been!

As King Solomon wrote thousands of years ago in Ecclesiastes 11, “Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land.”

So, I encourage you today to continue to be aware of your expectations when it comes to investing. A diversified portfolio’s overall performance will always be a blend of all your portfolio’s holdings as opposed to tracking with a single market index like the S&P 500.

In fact, this is one of the ways you can tell that the “process is working”—that your portfolio contains meaningful diversification and all your eggs aren’t in one basket!

Zak Lutz, CFP^®, RLP^®, CKA^®
LifeGuide Chief Investment Officer

*References: