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No Crystal Ball? Take these 3 Simple Steps to Help You Think Realistically about Your Financial Future

May 21, 2012
by Jack Reynolds

We are well into Q-2 2012; interest rates are at an all-time low, the U.S. economic recovery is painfully slow, and Europe may be back in a recession. As an investor, you are probably familiar with your quarterly and annual rates of return. However, without a crystal ball, what can you realistically expect to receive for an average rate of return over, say, the next 20 years? Further, how might this number change when you factor in inflation, taxes and fees?

Knowing your average rate of return, and net average return (after inflation, taxes and fees), can significantly influence your spending policies and plans for future growth. Below are three simple steps you can take to help you estimate a realistic net long-term rate of return for your portfolio. Going through this simple exercise will help you develop realistic expectations for long-term earnings, make more informed spending decisions and improve your chances of achieving your plans for future growth.

  1. Determine Your Average Rate of Return
    According to the popular press, investors with an allocation of 80% or more to diversified equities (e.g., developed, emerging and frontier markets, hedge funds and natural resources, etc.) can expect to earn an 8% gross return on average over 20+ years (this will vary based upon your particular asset allocation, manager selection and other factors). Since your net rate of return is affected by taxes, fees and inflation, it is essential that you also determine the impact that these three factors will have on your average rate of return if you truly want to make it realistic. Assuming that inflation will average about 2.5% over the long-run, we will turn our attention to taxes and fees.
  2. Determine the Tax Implications on Your Average Rate of Return
    The taxes that you pay on your average long-term rate of return will vary greatly over time based on several factors (e.g., where you live, evolving tax regimes, etc.). Researchers say that in general, taxes take a toll of between 1% and 2% on your annual investment return. For the sake of simplicity, we will use an estimate of 1.5%.
  3. Determine the Fee Implications on Your Average Rate of Return
    Investment management fees vary widely by investment type and manager, and tend to average about 1% depending upon the composition of your portfolio. Management fees for index funds and fixed income products, for example, tend to be lower (e.g., about 0.3% for fixed income) than management fees for private equity, venture capital and managed futures (e.g., up to 3% per year and 30% of your profits). In addition to investment management fees, you are likely to pay adviser fees to your financial planner, attorney, investment strategy consultant, accountant, trustee, custodian, family office, and/or bookkeeper, etc. All in, let’s suppose that your total investment-related fees are about 1.5%.

Summary: What is Your True Net Average Rate of Return?
When you sharpen your pencil to adjust your average long-term rate of return for inflation, taxes and fees, you will be able to estimate a realistic net return for your long-term investments. Here is an example based on $1 million in investment assets and the rough and ready assumptions above:

Gross investment return: 8% $80,000
Inflation: 2.5% ($25,000)
Taxes: 1.5% ($15,000)
Investment fees: 1.5% ($15,000)
Net average investment return: 2.5% $25,000

Knowing this information, a rational person might decide to spend less than their net average return, hoping to see growth in their investments over time. This perspective is especially important for growing families in which each successive generation tends to have more members than the prior generation. If a family’s assets do not grow in sync with the scale of the family, there is a risk that the family’s standard of living may decline, even precipitously. It is wise to have an open and candid discussion of investment expectations and net average long-term returns with key members of your investment team.

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