Foundations of Investments: Asset Allocation and Real Returns

I’m sure you know by now my assertion that having a good working knowledge of the foundation of finances is essential to your success as an investor. In my series of blogs covering foundational topics, we’ve already covered the importance of timelines as well as how certain investments and savings are taxed. I promised in my last blog that we’d get into actual investment choices today, but that might have been a little misleading. I’m not going to talk about stock picking today, but instead want to discuss asset allocation and what ‘real returns’ are. Depending on how educated you are about the financial industry, you may be well acquainted with real returns or this may be the first time you’ve ever heard the term. In this blog, I’ll go over what a real return is, what it means for your investments, and how you can use that to better allocate your assets.

Why You Should Spread Out Your Investments

When we start getting into the details of which investments have historically performed the best, you’re going to question why all your money shouldn’t go into the investment that makes the most money. It’s a valid question, and one that I usually answer with an analogy. Think of yourself as a gardener who wants to plant a beautiful flower garden. Would you choose to only plant lilies because they’re your favorite? Or would you instead choose to plant a variety of different flowers based on what time of year they bloomed, how their colors complemented each other, and their aromas? Most would choose the second option, and it’s the same with investments. You need to choose the right mix of investments because they all perform differently and will help you meet your goals in specific ways. Depending on your timeframe, risk tolerance, and other details, your financial counselor can help you put your money in the right places for a complete portfolio.

Average Returns on Popular Investments

Of course, we’re not flying blind when we help you choose the investments that will bring the best returns. You can easily look up the historic performance of different types of investments. For this blog, I went back ten years and determined the average annual return on three types of investments.

The first is large cap U.S. investments. There are large corporations based in the United States like Coca Cola or Google that have more than $10 billion in shares on the market. In the last decade, these have returned an annual average of 14.5%. International (which are considered any stock outside the U.S.) returned an annual average of 7.8% and U.S.-based corporate bonds returned 4.3%.

You probably all want to be in those large cap stocks, right? But it’s not that easy. While these had the highest returns in the last decade, they were also the most volatile while some of the other choices provided a more stable investment. But that’s also not where the story ends. To get ‘real returns’, we still have to look at a couple more variables.

How to Determine Real Returns

Real returns are the numbers you get after taking into consideration inflation and taxes. According to the Consumer Price Index, inflation is currently at 2.2%. However, some industries such as education experience a much higher rate, so this also needs to be considered. For simplicity’s sake, though, let’s stick with the 2.2%. When you take that out of the above numbers, you see that the large cap return shrinks to 12.3% while the corporate bonds dwindle to 1.1%. When you take taxes out of that, the number gets even smaller. These are the actual numbers you should be looking at and will give you a much better idea of what to expect with your investments.

So what does this all mean? Your financial advisor uses all the above information as well as personal information on your unique financial situation to help create a diversified portfolio for you that has the right combination of risk and returns. Once you are aware of how real returns are calculated, you can better understand what your advisor is trying to accomplish and be a better-educated advocate for your own finances.

I hope this series of blogs on the foundations of investments has been helpful to you! If you have any questions at all or would like clarification on the topics we discussed, please leave a question or comment below. I’d love to help out!