Return objectives

Return objectives are specific, measurable goals for the financial gain an investor seeks to achieve from their investments over a defined period. These objectives are a cornerstone of sound investment planning and fall under the broader category of portfolio theory. Establishing clear return objectives helps guide investment decisions, asset allocation, and the overall investment strategy.

What Are Return Objectives?

Return objectives represent the desired percentage or absolute gain an investor aims to realize from their capital. They typically quantify the expected increase in the value of an investment or portfolio. For instance, an investor might set a return objective of 8% annually for their long-term growth portfolio or target a specific dollar amount for a future purchase. These objectives are crucial for aligning investments with an individual's financial goals and are influenced by factors such as risk tolerance, time horizon, and the need for either capital appreciation or income generation.

History and Origin

The concept of setting specific return objectives gained prominence with the evolution of modern portfolio management and financial planning. As financial markets became more complex and accessible to individual investors, the need for structured approaches to wealth accumulation became evident. The professionalization of financial advice, particularly in the latter half of the 20th century, emphasized a client-centric approach where advisors work with clients to define clear targets.

Ethical guidelines from professional bodies, such as the Certified Financial Planner (CFP) Board, underscore the importance of understanding a client's financial situation, including their goals and objectives. The CFP Board's Code of Ethics and Standards of Conduct, for instance, mandates that financial professionals identify and select goals with the client, which inherently includes defining return objectives that are suitable and realistic.⁹,⁸ This framework ensures that investment recommendations are tailored to the individual's aspirations rather than being generic.

Key Takeaways

Return objectives define the specific financial gain an investor aims to achieve from their investments.
They are a critical component of personal financial planning and investment strategy.
Return objectives must be realistic, measurable, and aligned with an investor's risk tolerance and time horizon.
They help guide decisions on asset allocation, the selection of investment vehicles, and subsequent performance measurement.
Ignoring market realities or taking on excessive risk in pursuit of unrealistic return objectives can lead to significant financial setbacks.

Interpreting Return Objectives

Interpreting return objectives involves assessing their feasibility and suitability given an investor's unique circumstances and prevailing market conditions. A high return objective, for example, typically necessitates taking on higher levels of risk. Conversely, a very conservative objective might mean sacrificing potential gains, particularly when considering factors like inflation, which erodes purchasing power over time.

Investors and their advisors must consider various inputs, such as historical market returns, economic forecasts, and the investor's capacity for loss, to determine realistic return objectives. Objectives are not static; they should be reviewed and adjusted periodically as personal circumstances change or as market environments evolve.

Hypothetical Example

Consider an individual, Sarah, who is 35 years old and wants to save enough money to make a down payment of $100,000 on a house in 10 years. She currently has $50,000 to invest.

To determine her return objective, Sarah would use the future value formula, but for simplicity, we can calculate the required annual growth.
Future Value (FV) = $100,000
Present Value (PV) = $50,000
Number of periods (n) = 10 years

To find the required annual rate of return (r):

FV = PV * (1 + r)^n

\$100,000 = \$50,000 * (1 + r)^{10}

2 = (1 + r)^{10}

(2)^{1/10} = 1 + r

1.07177 \approx 1 + r

r \approx 0.07177 \text{ or } 7.18\%

Sarah's return objective would therefore be approximately 7.18% annually. This objective then informs her choice of investments; she would seek an investment strategy that has a reasonable probability of achieving this average annual return over a decade, taking into account her risk tolerance. She would also consider the power of compounding in reaching her goal.

Practical Applications

Return objectives are fundamental across various facets of finance:

Personal Financial Planning: Individuals set objectives for retirement savings, education funds, or major purchases, directly influencing their savings rate and investment choices.
Institutional Investing: Pension funds, endowments, and sovereign wealth funds establish stringent return objectives to meet their long-term liabilities and funding needs.
Investment Product Design: Mutual funds, exchange-traded funds (ETFs), and other investment products often have stated objectives (e.g., "seeks long-term capital appreciation") that guide their investment style and suitability for different investors.
Fiduciary Responsibilities: Financial advisors are legally and ethically obligated to understand a client's return objectives and recommend suitable investments. The U.S. Securities and Exchange Commission (SEC) provides guidance on the responsibilities of investment advisers, including understanding client objectives.⁷,⁶
Performance Evaluation: Actual investment returns are measured against these objectives to assess the effectiveness of an investment strategy. If a portfolio consistently underperforms its objective, it may necessitate a review of the strategy or the objectives themselves.⁵

Morningstar, for example, publishes capital market expectations that can help investors and advisors set more realistic return objectives by providing forecasts for various asset classes over different time horizons.⁴,³

Limitations and Criticisms

While essential, setting return objectives comes with limitations:

Uncertainty of Future Returns: Financial markets are inherently unpredictable. While historical data and financial models can inform objectives, they cannot guarantee future performance. Economic shocks, geopolitical events, and shifts in market conditions can significantly impact actual returns.
Risk vs. Return Trade-off: There is a direct relationship between potential return and risk. Chasing excessively high return objectives without a commensurate increase in risk tolerance can lead to inappropriate investment choices and potential losses. Critics of aggressive return targets often highlight the "loser's game" in trying to consistently beat the market, advocating instead for broad diversification and cost minimization.²,¹
Behavioral Biases: Investors can be susceptible to behavioral biases, such as overconfidence or anchoring, which can lead to setting unrealistic return objectives or failing to adjust them when market conditions change. This can hinder effective portfolio management.
Ignoring Other Factors: Over-focusing solely on return objectives might lead to neglecting other crucial aspects of a financial plan, such as liquidity needs, tax efficiency, or the overall risk-adjusted return.

Return Objectives vs. Risk Tolerance

Return objectives and risk tolerance are inextricably linked in financial planning and often confused or discussed interchangeably. While both are critical to building a suitable investment portfolio, they represent different concepts. Return objectives specify what an investor wants to achieve financially—the desired level of gain. Risk tolerance, conversely, defines how much volatility or potential loss an investor is emotionally and financially able to endure in pursuit of those returns. An investor with a high return objective but low risk tolerance faces a significant challenge, as higher returns typically require accepting greater risk. A prudent investment planning process ensures that desired return objectives are realistically balanced with the investor's capacity and willingness to take on risk.

FAQs

Why are return objectives important?

Return objectives are crucial because they provide a clear target for your investments, guiding your investment strategy, asset allocation, and overall financial goals. Without them, investment decisions can be arbitrary and lack direction.

How do I set realistic return objectives?

Setting realistic return objectives involves considering your time horizon, risk tolerance, current market conditions, and historical market performance. It's often beneficial to work with a financial advisor who can help assess these factors and temper expectations.

Can return objectives change over time?

Yes, return objectives should be dynamic. They can and often should change due to shifts in your financial goals, life circumstances (e.g., retirement, marriage, new dependents), or significant changes in the economic and market conditions. Regular review and adjustment are key to effective investment planning.

What happens if I don't meet my return objectives?

If your investments consistently fall short of your return objectives, it warrants a review. This might involve reassessing the objectives themselves (were they too ambitious?), adjusting your investment strategy or asset allocation, or increasing your savings rate to compensate for lower-than-expected returns. It's an opportunity for corrective action in your financial planning.