The investment product landscape is a mine field. The most dangerous products on the market are the ones designed to appeal to the fear and apprehension of investors; active management promises higher than market returns and lower volatility, segregated funds come with various guarantees, and principal protected notes are pitched as offering upside potential with no downside risk. In reality, all of these products enable financial companies to charge additional fees for a sense of security. If investors selected their investment approach based on appropriate expectations, they would not be distracted by expensive promises of safety, and their investment experience would improve dramatically.
Investors in actively managed investment products should expect to underperform the market after fees in most years, with the potential for some years of outperformance. They should understand that their returns are not only affected by the performance of markets, but by the performance of their manager within the market. This can make it much more difficult to set realistic expectations, and adds another obstacle in sticking to a strategy. If the fund underperforms, the investor may wonder if their manager is making the right calls.
Segregated funds also tend to be actively managed, and the above commentary applies to them, too. They also have death benefit guarantees and maturity guarantees that protect the initial investment, in exchange for higher fees. Investors may find comfort in the guarantees, but they should expect lower returns due to the higher fees. They should also expect that over the 10 years that it will take for their maturity guarantee to take effect, the market will likely have increased in value. In other words, the maturity guarantee that they are paying for is not particularly useful unless the fund has been underperforming the market.
Principal protected notes combine a guarantee of the initial investment with the opportunity to partake in some of the gains of an asset or a group of assets. These products are usually locked in for 5 years. Investors should expect that if the market crashes, they will not lose their initial investment, and if the market soars, they will not fully partake in the gains. They should also understand that over a 5-year period it is unlikely that the market will have negative performance, making the guarantee less valuable.
Index fund investors should have the expectation that each year they will capture the return of the index, less fees. There will always be active funds that beat the index each year, and index investors may need to remind themselves of the body of evidence that reinforces an index-based strategy. If they want a smoother ride, they will adjust their asset allocation toward fixed income, while acknowledging a lower expected return for doing so.
Some indexes have different expected risk and return characteristics. For example, an investor may choose to follow the evidence that small cap and value stocks are expected to outperform large cap and growth stocks over the long-term, and increase the weight of small cap and value stocks in their portfolio. They would expect higher long-term returns, with the trade-off of slightly higher volatility.
There are many investment products and strategies to choose from. With appropriate expectations set for any investment, it becomes much easier to make an informed decision that will be more likely to result in a positive experience.