Investigating the Misconception of Anticipated Yields
When it comes to building wealth and planning for the future, many investors with a moderate risk tolerance often assume they need a 10% annual return to achieve their goals. However, as history has shown, U.S. equities have averaged returns in the 9% to 10% range over the past century [1]. But the reality is, the 10% myth can lead to disappointment and panic when returns fall short, or, on the other hand, satisfaction with lower returns when they are all that is needed.
Gianluca Sidoti, an Independent Financial Advisor and the Founder of TraDetector, emphasizes that the focus should be on understanding what each individual's goals are—whether that's growth, income, or security—and what "freedom" looks like for them [2]. He often advises clients to aim for a plan that suits them, not the highest possible return.
The real risk in investing is not just the potential for low returns, but also the psychological factors that can lead to costly mistakes. Panic-selling during drawdowns, abandoning the plan during volatility, or investing in products not fully understood due to the pursuit of high returns are all examples of the psychological risks that investors face [3].
Instead of focusing on a specific return, investors should consider questions like "What is my minimum required return to meet my goals?" and "What can I control?" [2]. A portfolio with a lower return and low volatility might serve an individual's goals better than one with a higher return and high drawdowns.
The concept of expected utility is more important than expected return in investment planning because it incorporates an investor's risk preferences and attitudes toward uncertainty, not just the average monetary outcome [4]. While expected return is simply a weighted average of possible returns, expected utility accounts for the varying satisfaction or "utility" an investor derives from different outcomes, reflecting risk aversion or risk tolerance.
Expected return measures the average gain or loss from an investment without considering risk. For example, an investment with a 75% chance of 8% return and 25% chance of 14% loss has an expected return of +2.5%, but this alone doesn't tell if the risk is acceptable for the investor [4]. On the other hand, expected utility incorporates how much an investor values different results, adjusting for risk aversion. It is based on a utility function (u), where an investor might prefer a sure smaller gain over a gamble with a higher expected return but high risk, because the utility of losses weighs more heavily than equivalent gains [4].
This approach aligns with the Von Neumann–Morgenstern utility theorem, which formalizes rational decision making under uncertainty by maximizing expected utility rather than expected monetary value [4]. Utility value hence reflects the "welfare" or satisfaction an investor assigns to an investment considering both returns and risks, providing a more comprehensive framework for portfolio choice and risk management [2].
In conclusion, expected utility is crucial because it captures the trade-off between risk and return tailored to the individual's preferences, providing a more realistic and personalized basis for investment decisions than expected return alone. A smarter approach to planning involves asking questions about savings, lifestyle, volatility tolerance, preferences, and non-negotiables before building a portfolio backward from goals, not forward from a market myth.
[1] The 10% annual return is a common expectation among amateur investors. (Source: Forbes Finance Council)
[2] Gianluca Sidoti works as an independent financial consultant. He is also the Managing Partner at The Wealth Company International. (Source: TraDetector)
[3] The real risk is psychological, such as panic-selling during drawdowns, abandoning the plan during volatility, or investing in products not understood due to the pursuit of high returns. (Source: Forbes Finance Council)
[4] Expected utility refers to the value derived from an outcome, not just the outcome itself. (Source: Investopedia)
Gianluca Sidoti, as an experienced financial advisor, advises investigating personal goals and risk tolerance instead of chasing high returns for wealth management and personal finance. By considering the concept of expected utility, a more comprehensive framework for portfolio choice and risk management is achieved, which aligns with the Von Neumann–Morgenstern utility theorem.
In wealth-management and personal-finance planning, it is essential to prioritize understanding individual goals and risk preferences, rather than focusing solely on expected return or hunting for high returns, as the reality of psychological risks and the need for personalization in investment decisions is crucial.
