At Elevate, we know that investments are one of the core components of a well-designed, comprehensive financial plan. Investments play a crucial role; there to protect and grow your wealth, as well as to effectively transfer resources across time to fund future financial goals.
Given that everyone aims for a successful investment experience, how should we define the main goal of an investment portfolio? We might start with something very straightforward, such as:
1. “Maximize expected returns.”
That’s a good start, but that definition ignores some other important considerations that might help us arrive at a better definition.
First, an investment portfolio with high expected returns won’t do any good if it’s too difficult to hold. By focusing only on the return component, you would be naturally inclined to include only the most speculative kinds of securities. But that kind of portfolio would be so volatile that drawdowns would be frequent and extreme and very few investors could hold on to it for the long run. In other words, the risk of a portfolio is very important, as well, and it needs to match the investor’s preferences. Now we can improve our portfolio goal definition to:
2. “Maximize expected returns for a given level of tolerable risk.”
However, this definition is still inadequate, because we’ve ignored one of the main goals of a comprehensive financial plan, and that is to maintain and grow your purchasing power over time. Purchasing power only improves if investment returns exceed the background rate of inflation over time. (i.e., a portfolio that earns 6% annually will leave the owner in a worse position if inflation is running at 9%). So, we should refine our portfolio’s goal definition further by targeting real (inflation-adjusted) returns, rather than “nominal” (not inflation-adjusted) returns. So, now we have:
3. “Maximize real (inflation-adjusted) returns for a given level of tolerable risk.”
But we can still do better. Since investment gains and income are subject to taxes in the U.S., we need to be aware that a significant portion of solid returns can be lost to taxes without careful planning. In fact, minimizing taxes, both inside and outside of the portfolio, can have a major impact on the ability to maintain your lifestyle during retirement. Incorporating this fact into our portfolio goal definition leads to:
4. “Maximize real, after-tax returns for a given level of tolerable risk.”
We’re almost there. But we can’t forget about fees and expenses. Transaction costs, brokerage commissions, mutual fund expenses, and management fees should be minimized to the extent possible so the investor can keep what they have earned. This leads to our best and final definition of the goal of our portfolio, which is to:
5. “Maximize real, after-tax returns for a given level of risk, net of all expenses.”
It’s quite a mouthful, but definition (5) is the hallmark of a well-designed, efficient portfolio. This is why things like rebalancing, diversification, tax efficiency, and cost control are so important to an investor’s overall experience. Having the right goal from the outset will help keep your focus on the real prize.