Feb 11, 2016
What Return Will I Get On My Investments? (AKA “The Run/Pass Analogy”)
Written By: Nate Williams
When having discussions about investments with clients, there is one question we get more than any other…
What return will I get on my investments?
It’s a great question. In our long-term financial plans we have to use a long-term estimate of market returns, so in a way we’re forced to answer this question. As such, our clients sometimes expect us to know the answer. After all, you can walk to the bank and they tell you exactly what the interest rate will be on a CD or savings bond. Can’t you do the same thing with all investments?
Let us ask you a similar question: what exactly will the profits in your business be next year? And if we were investors in your business, what would be our exact return be? You don’t know for sure. In fact, you can’t know. Will there be a recession? Will all your patients disappear like so many doctor’s fear? Will you break your arm and be unable to perform your duties? Regardless, of the variables we simply can’t know what the return will be. Should that keep you or me from investing in your practice? No!
As you can see from the chart above, during the 90-year period from 1926 through 2015 the average annual return for Small stocks was 12.2%. Does this mean small stocks will gain 12.2% going forward? That would be nice, but don’t know. But aren’t we suggesting that we think they will? We hope so.
Let me share the perfect analogy to make this clear:
Let’s compare this question to the beautiful game of football. In football, the offensive goal is to score touchdowns. In order for your offense to cross the goal line and score a touchdown, the options are simple: run the ball or pass the ball. There is no other way. There are a lot of ways to run and a lot of ways to pass (e.g. mix players around, disguise plays, pass short or long, etc.); but in order to move the ball, you only have two choices: Run. Pass.
You are now the head coach of a football team. So let us ask you, coach: how many yards are you going to get on the next play if you run? And how many yards will you get on the next play if you pass? And if you run or pass, what is the probability that you will get the desired number of yards? Let’s expand the scope of the question: how many running and passing yards will you get in the next game?
You don’t know. Admit it. You have no idea. So does that mean you shouldn’t run or pass? If not, then what do you suggest? Punt?!
You know how many yards you’ve gotten in the past; and if you’re a smart coach you can figure out why and how. But you have no clue what that will mean for the next play, or game, or season for that matter! The same principle applies to your business. You don’t know how much money you’ll make next year. You think you know and we will help you project, but you don’t know for sure!
Fortunately it doesn’t matter. Nobody knows. You don’t need to know and you shouldn’t waste your time caring about that. You don’t need to know how many yards you’ll get; you only need to know how to get yards! And the only way to move the ball is to run and pass. Winning in football is about knowing how and why the ball moves up the field, and using that knowledge to beat your opponents.
Investing is exactly the same way. With investing, the goal is profits and ultimately the realization of your financial plan (your own financial Super Bowl). To accomplish your plan, you’ll need an investment return (move the ball and score touchdowns). And to obtain a return on your investment (your share of the company profits) you only have two options: loaning money to a profitable company, aka bonds (running); or buying ownership in a profitable company, aka stocks (passing). There is no other way.
Although we don’t know the future, let’s return to and focus on what we do know:
- We know that we only have two choices: run or pass, stocks or bonds1.
- We know our historic average run per carry and the standard deviation of those runs (returns on bonds and standard deviation).
- We know the same historic stats for passing (returns on stocks and standard deviation).
- We understand how and why we earned those historic returns, and how and why we might earn them in the future.
- We know that if we carefully mix running and passing (stocks and bonds), we’ll be able to increase the average yards (return) and minimize the risk of no yards (probability of success).
- We know that if we mix up our plays and run a lot of different plays (diversify our investment portfolio), we’ll have a higher probability of success.
- We know that regardless of what the defense does, if we focus on our own decisions and our own preparation, we’ll increase our chances of victory (we make the right financial decisions and focus on what we can control – our earning, spending and investing).
Sadly, because many doctors do not know what return they will get, and they don’t focus instead on HOW returns are made, they do nothing – they punt the ball!
Our advice to you on this topic is simple: focus on what you can control – earning profits in your practice, your spending and how much you invest. Work with an experienced financial advisor who not only has a proven, future-focused investment philosophy, but also knows you and your comprehensive financial situation. Stay focused on the long-term (your financial plan) and keep investing. Remember, regardless of the return, which you can’t control, the more times you run or pass (the more you invest), the more yards you will get (the more investment return) and the higher probability you will have of winning!
The accurate answer is that when it comes to reading the future we don’t know exactly what rate of return you will get on your investments. We have a good idea what they may be over the long term, but an exact answer is impossible to give. Yes, we do make projections, but they are just that – projections. And when the actual rate of return differs from the “projected” rate of return, or the investor’s expectations, some clients wonder if something is wrong with the program or if they should hire a different advisor.
Before you give up on your investment plan, let us suggest that you may be asking the wrong question. It is true: we don’t know exactly how much money you will make on your investments. And we don’t know anyone who does (except for Biff in Back to the Future II). But even though we don’t know how much money you will make on your investments, we do know how you will make money on your investments. And the answer to that question lies the secret to your investing success.
If you have any questions or would like to discuss this topic further, please email or call us.
- Remember, Stock = ownership, Bond = loan. Please read more (here) on this subject.