Targeting unrealistic returns is one of the biggest mistakes you can make in investing. The reason why targeting returns can be so dangerous is it pushes you to make risky bets. In doing so, investors can overlook what is the most important factor in any investment strategy, risk.
Klarman on risk
Speaking at a meeting of the MIT Sloan Investment Management Club on Oct. 20, 2007, Seth Klarman (Trades, Portfolio) made the following comments regarding returns targeting:
"For 25 years, my firm has strived not to lose money -- successfully for 24 of those 25 years-- and, by invest and cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio-- and with risk comes losses. Some investors target specific returns. A pension fund, for example, my target an 8% annual gain. But if the blend of asset classes under consideration fails to offer that expected result, they can only lower the goal-- which foremost is a non-starter-- or invest in something riskier than they would like."
This isn't the first time a well-known investor has cautioned against the practice. At the 2001 meeting of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) investors, CEOÂ Warren Buffett (Trades, Portfolio) criticized pension funds that were targeting extremely high long-term returns.
Aiming too high
At the time, Buffett believed that over the long term, corporate profits would not exceed around 6% of gross domestic product.
He said this was an appropriate level and it was unlikely that over the long term, corporate profits would ever reach levels of 10% to 12% of GDP because it "would look like an unfair division of pie to the populace." Unfortunately, this statement didn't age well.
Corporate profits have indeed increased to more than 10% of GDP over the past decade. Although they have since started to decline, corporate profits as a percentage of GDP hit an all-time high of nearly 12% in the first quarter of 2012.
Buffett concluded it is unlikely stock markets will produce a return higher than corporate profit growth over the long term. Therefore, while stocks looked to be a "perfectly decent way" to make 6% to 7% a year, "anybody that expects to make 15% per year...is living in a dream world."
Based on this conclusion, Buffett went on to explain that in his mind, most pension funds, which were predicting returns of 9% or better on their investments at the time, had their heads in a cloud.
The Oracle of Omaha then went on to accuse many companies of using excess returns data because they wanted to inflate their earnings. If they reduced returns targets, companies would have to increase pension contributions and revalue their pension pots, which would have a negative effect on the income statement.
Referring to the 9% annual return most companies were targeting at the time, Buffett said:
"They don't know how to get it in the bond market. They don't know how to get it in the mortgage market. I don't think they know how to get it in the stock market. But it would cause their earnings to go down if they change their investment assumption."
Problems still exist
It seems many pension funds still haven't learned this lesson. Figures show U.S. state pension plans assume they will achieve relatively high annual returns of about 7.15% per annum, but most are missing this target.
According to research from Pew Charitable Trusts, the combined deficit across 230 public pension plans grew to about $1.5 trillion at the end of 2018.
Avoid the returns trap
This is a crucial lesson for the average investor saving for retirement. It is essential to be realistic about investment returns for two reasons. First, to avoid taking on too much risk in the hunt for market-beating performance. And second, to ensure you are not left out of pocket when it is time to retire.
Both of these factors are linked. If you don't think you are going to have enough money to retire on, you might take more risk in search of higher returns. That could end in disaster and undo years of hard work.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- Warren Buffett, Mr. Market and the Secret to Investing Success
- Value Investing Dead? It Is According to This Study
- 4 Negative Enterprise Value Stocks
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