Return targets

Return Targets

Return targets are specific, measurable objectives for the growth or income an investor seeks from their investments over a defined period. These targets serve as a crucial component of sound portfolio management and financial planning, providing a benchmark against which investment performance can be measured. Unlike general aspirations, return targets are quantitative and are typically set after considering an individual's financial objectives, time horizon, and risk tolerance. They guide investment strategy and asset allocation decisions, helping investors align their expectations with their financial reality.

History and Origin

While the concept of aiming for specific returns has always been intrinsic to investing, the formalization of "return targets" as a distinct element of personal financial planning emerged with the professionalization of the financial advisory industry. Prior to the mid-20th century, financial advice was often transactional, focusing on specific products like insurance or stocks. However, as individuals' financial lives became more complex, the need for holistic planning grew. A significant turning point occurred in 1969, when a group of financial professionals gathered in Chicago to lay the groundwork for a new profession that would integrate various areas of financial services. This movement ultimately led to the establishment of organizations like the Certified Financial Planner (CFP) Board, formalizing the practice of comprehensive financial planning that includes setting explicit objectives such as return targets for various long-term goals.⁵

Key Takeaways

Return targets are specific, quantifiable objectives for investment growth or income over a set period.
They serve as a vital guide in portfolio construction and the development of an investment strategy.
Realistic return targets consider historical market performance, current economic conditions, and an investor's individual circumstances, including their risk tolerance.
Achieving return targets is not guaranteed and requires consistent monitoring, potential adjustments to the investment approach, and discipline.
Setting well-defined return targets helps bridge the gap between financial aspirations and actionable investment decisions.

Formula and Calculation

Return targets are not calculated by a single universal formula but are often derived from the desired future value of an investment needed to meet a specific financial goal. They represent the compound annual growth rate (CAGR) required to reach a future sum from a present investment, or the necessary rate of return to sustain withdrawals.

The basic future value (FV) formula can be rearranged to solve for the required rate of return (r), which would be the return target:

FV = PV * (1 + r)^n

Where:

(FV) = Future Value (the financial goal)
(PV) = Present Value (current investment capital)
(r) = Rate of return per period (the target return)
(n) = Number of periods (time horizon)

To solve for (r):

r = \left(\frac{FV}{PV}\right)^{\frac{1}{n}} - 1

For example, if an investor has a present value of $100,000 and needs to reach a future value of $200,000 in 10 years, the required annual return target would be calculated as:

r = \left(\frac{\$200,000}{\$100,000}\right)^{\frac{1}{10}} - 1

r = (2)^{0.1} - 1

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

This calculation helps establish a specific return target needed to achieve the financial objective, assuming consistent compounding over the period.

Interpreting the Return Targets

Interpreting return targets involves understanding their context within a broader financial plan. A return target should be viewed as a guiding principle rather than a guaranteed outcome. It helps investors determine if their current investment approach and capital are sufficient to meet their objectives within their desired timeframe. If a calculated return target is significantly higher than realistic historical returns for a given asset allocation or risk level, it signals a potential need to adjust the goal, increase savings, or extend the time horizon. Conversely, a target lower than achievable historical averages might indicate an overly conservative approach, potentially leading to missed opportunities for capital appreciation. It is also important to consider external factors like inflation, which erodes purchasing power, meaning that nominal return targets need to be higher to achieve real growth.

Hypothetical Example

Consider an individual, Sarah, who is 30 years old and wants to accumulate $1,000,000 for retirement by age 60. She currently has $50,000 saved for retirement. Her time horizon is 30 years.

To determine her annual return target, Sarah would use the formula:

r = \left(\frac{FV}{PV}\right)^{\frac{1}{n}} - 1

Given:

(FV) = $1,000,000
(PV) = $50,000
(n) = 30 years

r = \left(\frac{\$1,000,000}{\$50,000}\right)^{\frac{1}{30}} - 1

r = (20)^{\frac{1}{30}} - 1

r \approx 0.1066 \text{ or } 10.66\%

Sarah's calculated return target is approximately 10.66% per year. This figure informs her that, with her current savings and desired timeframe, her investments would need to grow by about 10.66% annually to reach her $1,000,000 goal. This helps her assess if this target is realistic based on historical market performance and adjust her plan if necessary, perhaps by increasing her contributions or reconsidering her desired retirement age.

Practical Applications

Return targets are widely applied across various financial scenarios, guiding both individual and institutional investment decisions. In personal finance, they are fundamental to retirement planning, determining how much an individual needs to save and at what rate their investments must grow to achieve a comfortable retirement income. Similarly, they are crucial for planning large expenditures such as college education, a down payment on a house, or funding a business. For institutional investors, such as pension funds or endowments, return targets dictate their asset allocation and risk management strategies, ensuring they can meet future liabilities or spending needs. These targets are often informed by comprehensive data on long-term market performance. For instance, historical data on asset classes, such as that provided by NYU Stern, helps establish realistic expectations for long-term investment growth.⁴ Furthermore, government resources like those from the Social Security Administration offer tools and information critical for individuals to incorporate anticipated benefits into their overall retirement return targets.³ Return targets also play a role in setting expectations for income generation from investments, especially for retirees or those living off their portfolios.

Limitations and Criticisms

While essential, relying solely on return targets has limitations. One significant criticism stems from the inherent uncertainty of financial markets. Future returns are never guaranteed, and setting rigid return targets can lead to investor frustration or irrational behavior during periods of market volatility. Achieving ambitious targets may necessitate taking on excessive risk, which can lead to substantial losses if markets underperform.

Behavioral finance highlights several biases that can affect an investor's ability to set and adhere to realistic return targets. For example, overconfidence can lead investors to set targets that are unrealistically high, believing they can consistently outperform the market.² Similarly, loss aversion can cause individuals to hold onto underperforming investments longer than advisable, hoping to avoid realizing a loss, thus making it harder to meet their original return targets.¹ The discount rate used in calculations might also be overly optimistic. Furthermore, unexpected events like economic crises or significant changes in inflation can render pre-set return targets unachievable without substantial adjustments to the investment approach or financial goal itself. Therefore, while return targets provide a useful framework for performance measurement, they must be approached with flexibility and a clear understanding of market realities and human behavioral tendencies.

Return Targets vs. Investment Goals

Although often used interchangeably, "return targets" and "investment goals" have distinct meanings. An investment goal is the broader financial objective an investor aims to achieve, such as saving $1 million for retirement, funding a child's college education, or accumulating enough wealth to purchase a home. It's the "what" and "why" of investing. A return target, on the other hand, is the specific annual percentage rate of growth or income required from investments to meet that broader investment goal within a defined timeframe. It's the "how much" in terms of growth needed. Investment goals set the overall direction and purpose for investing, while return targets are the quantifiable benchmarks that help measure the feasibility and progress toward those goals, informing the specifics of the investment strategy and required contributions.

FAQs

What is a good return target for an investment?

A "good" return target is highly individualized and depends on your specific financial goals, time horizon, and capacity for risk. Historically, diversified portfolios have generated average annual returns over the long term that can serve as a benchmark. However, past performance does not guarantee future results, and what is considered good must align with your personal financial plan.

How do I set realistic return targets?

Setting realistic return targets involves assessing your financial goals, the amount of capital you can invest, and your investment timeframe. Crucially, it also requires understanding historical market returns for various asset classes and considering current economic conditions. It's often advisable to use conservative estimates to avoid setting unrealistic expectations.

Can return targets be adjusted?

Yes, return targets should be reviewed and adjusted periodically. Life circumstances change, market conditions evolve, and initial assumptions may prove inaccurate. Regular review is a key part of effective portfolio management, allowing you to modify your return targets, savings rate, or time horizon to stay on track with your financial objectives.

Are return targets guaranteed?

No, return targets are never guaranteed. They are aspirational benchmarks based on projections and assumptions. Investment returns are subject to market volatility, economic factors, and other risks, meaning actual returns may deviate significantly from targets. Responsible financial planning accounts for this uncertainty.