The Old Ball Game
Over the last several months everyone has been impacted by the fallout of the Novel Corona Virus in one way or another, and will likely, continue to be for months if not years ahead. From a planning perspective, it was necessary to quickly revisit the assumptions return assumptions for various asset classes we incorporate into our financial plans.
Normally at this point in the year baseball season is in full swing, but 2020 has certainly thrown us all a curve ball. America’s greatest past-time is an excellent analogy to draw from for the financial planning process.
The expected return is the profit or loss an investor anticipates on an investment or portfolio. It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling those results. Similar to how statistics are monitored for baseball players, it is important to note that while two investments may have two identical expected returns (batting averages), their risk profiles (on base percentage) may be vastly different, that is the variance of those returns. We can use these expected returns of various asset classes to generate an expected return for an entire portfolio, just as baseball analytics are used to create winning teams. This is essential for financial planning as it will assist in determining if goals and objectives are achievable given a certain level of risk and a return or not.
Prior to the Pandemic and in previous The Artisan articles we have taken the view that we are entering the “late stages of the ball game.” To put this analogy in perspective, lets consider the late 90’s where long term portfolio expected returns were in the high single digits, to low teens. Like a ball game, this was a relatively simple part of the entire game from the managers perspective. A line up for the game was created and a pitcher was sent in for the first 4 or 5 innings and in most games, there was no need to pull a pitcher early. In the investment universe this was akin to passive investing--not much active management was required to get a good outcome.
As we enter the later stages of the “the ball game,” things get a bit more challenging and the manager knows he needs to go to the bullpen and start more active decision making. Portfolio managers such as Northland began to utilize alternative assets with active management as the outlook on long-term returns for public market investments such stocks and bonds began to be reduced.
Corona virus has now accelerated us from the 7th or 8th to the 9th inning, and we may end up going into extra innings. Those runs become ever more challenging to manufacture and their effect on the game is ever more meaningful to the game, just as investment returns are in this current environment.
Although a “U” shaped correction may provide significant annual returns from the bottom of the market, it is the longer-term averages that must be focused on. Furthermore, the volatility of returns creates a great challenge with what is referred to as variance drain. For example, if you hit a home-run every ten at bat, but strike out the other nine, you will have a very unimpressive batting average of .100; yet many will bask in the glory of the home run. However, if you hit 4 singles out of every 10 at bat, you will likely make a bigger impact on the team over time with a 0.400 batting average.
At Northland, we have always been conservative in our estimates of expected returns, typically below that of the planning industry. In addition, we have chosen to focus on probabilities of success using Monte-Carlo analysis (variance of returns) vs the typical straight-line analysis often used in more simplistic planning. We also tend to focus on the “what you actually eat,” aspect of returns with absolute benchmarks. Simply put, these are return metrics that take into account the cost of inflation which will be ever more important in the years ahead. It is great if you are achieving 10% returns but if inflation is at 6% then your real return, (what you eat), is only 4%. This is the same as getting 10 runs in the 5th inning, but the other team gets 6.
Revisiting your plan every few years or when there is a significant change in your financial situation is prudent. However, due to our conservative approach, we have found that more often than not, our clients are pleasantly surprised that they are ahead of their plan, largely due to the implementation of realistic objectives. It is better to underestimate and be rewarded, than overpromise and underdeliver.
Our future is going to be quite different than was anticipated only a year ago. As mentioned in a previous planning files article, it is better to plan for the worse, than hope for the best! In baseball you cannot win by too much, but you certainly can hand over a game to the other team, by not being prepared nor remaining focused on the task at hand.
All clients of Northland are encouraged to complete a Life Plan with one of our seasoned Financial Planners, to ensure that not only are you in the ball park, but that you have the potential to knock one out of the park!