Would you rather earn 5% on your investments or 7%? (Hint: it’s a trick question.)

Bob Collie, blogging live from Russell Investments Institutional Summit
Bob Collie, blogging live from Russell Investments Institutional Summit

Russell’s Institutional Summit conference is currently taking place in Dana Point, California. Over the course of two days, attendees hear from 28 Russell presenters and three guest speakers; topics range from the outlook for the global economy, to the changing state of the energy industry, to the unique challenges facing different types of investor including health care systems, frozen pension plans and 401(k) plan sponsors. Over the next two days, I will be posting snippets of the content delivered by selected speakers at this event.

Mike Thomas (the Chief Investment Officer of Russell’s Americas Institutional business) opened the Summit with a keynote on the subject of investment myths. The myths that he addressed included the idea that monetary expansion inevitably leads to inflation (not necessarily true) and that a year of strong market returns—such as 2013—will usually be followed by a bad year (again, not necessarily true.)

My favorite of the three myths he covered, though, was the idea that a higher return on your assets (7% per year for example) is always better than a lower return (5% a year, say.)
Which doesn’t sound like a myth at all. If Mike had solely been talking about expected returns, his claim would not be so surprising: after all, most readers probably agree that a higher expected return tends to come with a higher degree of uncertainty attached, and that there’s no guarantee of actually getting the return that you expect. But that a lower actual return can be better than a higher actual return is much more surprising.

To see why it’s a myth that a higher return is always better, consider the example of a fully funded pension plan that has frozen new benefit accruals. Suppose 5% a year is the return required to maintain full funding and for the plan sponsor to avoid being required to make further contributions. So 5% a year is enough. If a 7% return is earned over time, but earned in a volatile manner (perhaps -3% the first year, 17% the next) then funding can dip below 100% at some point and contributions will be needed. That’s a worse outcome, even with a higher return.

The same principle can apply to an individual who must manage a defined contribution account balance to provide a lifetime of retirement income or a nonprofit organization aiming to meet a known spending goal. Obviously, a higher return is usually good news – but not always. That’s why success needs to be defined and measured in terms of the outcome for the investor, not just in terms of the return earned.


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