The false goal of maximizing investment returns

By Philip Brewer on 16 August 2007 (Updated 18 August 2007) comments

Along about the middle of the dot-com boom--when the market had already had two years of 20% annual gains--I read an article that suggested that individual investors had no need of a cash reserve, because they could use credit cards in an emergency.

As I explained in my article about the credit squeeze , I think keeping a cash reserve is especially important right now, but I mention this article because I think it highlights a fundamental distinction in the way people think about investment returns.

Maximum investment returns

The article had a whole investment program, suggesting that you dispense with a cash reserve and instead invest 90% of your money in an S&P 500 stock fund and 10% of your money in zero-coupon bonds with a maturity date the same as your planned retirement date. When it was time to retire, you'd have three year's spending in zero-coupon bonds, plus about ten times that in stocks. The plan was to move the newly matured zero-coupon bonds into cash and use that money for day-to-day spending in retirement. Each year you were supposed to check the stock market performance and sell enough stocks to top off your cash account with enough to support three years spending--unless the market was down that year, in which case you waited a year and did the calculation again. Only if the market were down three years in a row would you need to sell stocks in a down year.

If you had a financial emergency before retirement, you just charged it on your credit card. You could then pay the debt off from current income. If current income wouldn't cover it, you could sell stock to cover it--but you could do it at a time of your own choosing.

People with a reasonably secure job in a reasonably secure industry could probably take the risk of having no cash reserve, and they'd probably come out ahead over a thirty year career by putting 90% of their money in stocks.

Supporting your goals

I think that plan is a bad one. The reason is not that it doesn't maximize returns--it probably does. The reason is that the goal of an investment portfolio is not to maximize returns. The goal of an investment portfolio is to support the investor's life goals. An investment portfolio has done its job if it:

  • provides the capital to make major purchases along the way (a car, a house, tuition),
  • provides a financial cushion against the vicissitudes of life, and
  • lets the investor retire at a suitable standard of living,

all without taking income that's needed to support daily living.

Extra return over that is not a win if its cost is a level of risk that endangers the investor's financial plan rather than supporting it.

Have a life plan. Evaluate your investment portfolio for whether it supports that plan. Be suspicious if your plan is criticized for "not maximizing returns." The goal isn't maximum returns. The goal is returns that support your plan.

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Edward

Always enjoy your articles, Philip! I think they're some of the most sensible things I read in the PF world. One of my best friends just posted about his -8.8% portfolio loss on Facebook. Said he'd been trying to "maximize returns" through an "aggressive strategy' his advisor recommended. Ersh... And in a year where the markets have done fairly well?! Just to rub it in I mentioned that with inflation, he was probably looking at more like -10%. I veered him toward a conservative index-investing based couch potato approach. Hope he heeds the advice and moves at least some of it toward that way of thinking.

Keep the good ones coming, buddy--I'm a fan!