The first category of your investment plan is risk and return objectives. This category describes your expectations for returns on your investments. These expectations will, to a large extent, determine your asset-allocation decisions. In other words, these expectations will determine how you will distribute your investments among different asset classes. This category also addresses your expectations for risk and outlines how much risk you are willing to accept.

Expected returns: You should not invest without specific goals in mind. For your first goal, you should decide what return you expect your total portfolio to make over a specific time period. You cannot know with certainty what the actual returns will be before you invest. However, you can estimate an expected return, or a goal that you hope to achieve during a certain period of time (such as a week, a month, or a year). Be aware that your expected return will have a major impact on what your portfolio looks like.

An expected annual return of 2 to 3 percent will likely be the result of a well-diversified, very low-risk portfolio.

An expected annual return of 4 to 6 percent will likely be the result of a well-diversified, low-risk portfolio.

An expected annual return of 7 to 8 percent will likely be the result of a well-diversified, moderate-risk portfolio.

An expected annual return of 9 to 10 percent will likely be the result of a less-diversified, high-risk portfolio.

An expected annual return that is greater than 10 percent will likely be the result of an undiversified, very high-risk portfolio that is heavily dependent on high-risk assets.

 Note that you will determine your expected returns for two periods of time: before retirement and during retirement.

There are several ways to estimate your expected returns. To give you an idea of how to estimate your expected returns over a period of time longer than one year, it may be helpful to look at the long-term history of the asset classes you have selected. Look at Learning Tool 23: Historical Return Simulation in the Learning Tools directory of this website to see the historical returns for various asset classes from 1926 to 2009.

Expected risk: Since a higher expected return requires you to accept more risk, it is important that you know your risk-tolerance level, or your willingness to accept risk. The place you are at in your life will likely have a big impact on how much risk you are willing to take. In general, when people are younger they are more willing to accept risk because their investments will have more time to grow and overcome loses. As people grow older, they usually become less willing to accept risk because they will need their investment funds sooner for retirement and other purposes. Investors that have a low tolerance for risk should typically devote the majority of their portfolios to bonds and cash because these investments are the least risky of all asset classes; however, these investments also have the lowest returns. Investors that are willing to accept more risk may allocate more of their portfolio to U.S. and international stocks, versus investments in bonds and cash. The challenge of wise investing is to balance your risk and return expectations with your situation in life and your personal goals.

Defining risk in your portfolio is a challenge. Professional investors usually state an annual standard deviation as the acceptable risk level for their portfolio—for example, 12 percent. From a financial standpoint, this means that 66 percent of the time the investor’s risk will be within one standard deviation (plus or minus 12 percent) of their mean or average return. If an investor’s average return is 8 percent, this means that there is a 66 percent chance that the investor’s returns will be between -4 percent (8 percent - 12 percent) and 20 percent (8 percent + 12 percent). While using a standard deviation to define risk may be helpful for some, this method will not work for everyone. I would like to propose a more simple way of defining risk: using investment benchmarks.

Instead of defining your risk tolerance level in terms of a standard deviation, you can simply define your risk tolerance level by deciding that you are willing to accept the risk of the benchmarks you have chosen for your portfolio. You can determine how risky a particular asset is by looking at your investment benchmark. If you have a small-capitalization stock mutual fund or asset that has had a return of 7.5 percent over the last ten years and a standard deviation of 25.3 percent, you can compare this asset to an investment benchmark for small-capitalization stocks. From Chart 18.1 of the previous section, note that small capitalization stocks have yielded an 6.3 percent return over the past ten years with a 23.9 percent standard deviation. Your mutual fund or asset has a slightly higher return than the benchmark (7.5 percent versus 6.3 percent), but it is slightly more volatile or risky than the benchmark (25.3 percent versus 23.9 percent).

You can also determine a portfolio’s risk level by comparing the portfolio to weighted individual benchmarks. For example, if you choose a portfolio that is made up of 50 percent U.S. stocks, 20 percent international stocks, 25 percent bonds, and 5 percent real estate (all percentages should add up to 100 percent), then your risk is equal to the risk defined by the benchmarks of each of these asset classes. In this case, your risk would be equal to the benchmarks of each element in a portfolio that contains 50 percent U.S. stocks (as measured by Standard and Poor’s 500 Index, a major benchmark for large-capitalization stocks); 20 percent international stocks (as measured by MSCI Europe Australia, Far East Index, or EAFE, a major benchmark for international stocks); 25 percent bonds (as measured by the Lehman Aggregate Index, a major benchmark for bonds); and 5 percent real estate (as measured by Standard and Poor’s REIT Index, a major benchmark for real estate investment trusts). A list of the major benchmarks for a portfolio can be found in the Teaching Tools directory of this website under Learning Tool 15: Possible Benchmarks for Investment Plans and Learning Tool 27: Expected Return Simulation and Benchmarks. Asset class performance can be found in Table 18.1 in the previous section of this website.