The Most Important Question to Ask Before Investing

No one would consider starting a business, a nonprofit or even a needlepoint project without asking themselves, what is my objective? However, when it comes to investing, most people don’t think twice before plowing money into financial markets. They never ask themselves the most important question: Why am I risking capital in the financial markets?

It’s About the Creation of Cash

There is no end to the financial goals people hope the financial markets can help them achieve: investing for retirement, paying for college, or buying a house. But no matter what your motive, the ultimate goal is wealth creation.

You might be saying to yourself, “I don’t need to create wealth, I’ve already built a nest egg and just want to hold on to what I have.”

Well, unless you're interested in having the purchasing power of your present wealth cut in half over the next 20 years, then you’re going to need to create some wealth. That statement is true whether you’re worth $1, $1 million, or even north of $10 million.

While we're all after wealth creation regardless of our place on the ladder, the greatest difference between investors is the annual rate of return that each of us believes is acceptable.

Benchmark Nonsense

Before I dig in, I need to get something off my chest. I’m not sure where the idea of basing investing success solely on outperforming an arbitrary basket of stocks, like the S&P 500, came from but it’s completely irrelevant to wealth creation. The only benchmark you need to be concerned with is whether your investment process met your desired rate of return or not. Period.

If you’re one of those investors who staunchly believe in benchmarking as a viable way to define investing success, then riddle me this: In 2008, the S&P lost almost 40% of its value. If your account lost 33% of its value would you have felt successful?

You outperformed the S&P by 700 basis points during a crisis! The reality is yes, you outperformed the S&P but you lost one-third of your wealth in 12 months.

Let’s flip the scenario and say that the S&P is up 40% one year while you gain 33%, do you consider that year a failure? If the answer is “yes,” then you need to educate yourself on historical asset returns. (For related reading, see: What Are the Pros and Cons of Using the S&P 500 as a Benchmark?)

Rate of Return Reality Check

On determining your preferred annual rate of return, I would caution you against setting any goals that require a consistent annual rate of return greater than 10%. If you take a quick peek at data from Morningstar, a company that tracks all things money management related, you see the reality of the investing game.

Morningstar tracks 22,388 domestic mutual fund and separate account managers with a 10-year track record. Of those managers, only 564 have annualized returns greater than 10%. Despite experiencing one of the best bull markets over the last eight years, only 2% of those professional money managers earned double-digit returns.

And if you think hiring a hedge fund manager will solve your problems, think again. Just 10% of hedge fund managers with a 10-year track record have earned annualized returns greater than 10%.

The bottom line is that unless you think you have the stuff of legends, your rate of return objective should be in the single digits if you want a realistic shot at meeting your objective.

Once you've decided your ideal rate of return, then you can decide how to put your money to work. The most common options are to hire a financial advisor, invest with a private fund manager or investment advisor, do it yourself or some combination of all three. No matter which door you choose, it’s critical that you focus on the net returns of the investment strategy or professional asset manager in question. When I say 'net,' I mean net of all fees (management, distribution, transactions, incentive allocation) and taxes. (For related reading, see: Pay Attention to Your Fund's Expense Ratio.)

Proper Due Diligence

I’ll be the first to admit that deciphering the net return and understanding all the fees involved can be a bit more arduous at times, especially in mutual funds.

To understand the true costs of a mutual fund, you must include the distribution and transaction costs in your analysis. The distribution costs can be determined by looking in the fund’s prospectus but the transaction costs (or the commissions paid for trading) are more difficult numbers to determine.

Popular sites like Morningstar don't include distribution or transaction costs in the total return calculations for mutual funds. For example, Morningstar says that a certain mutual fund, which will remain nameless, has an expense ratio of 1.4% and a 10-year return of 7.2%. The reality is that the total annual fees for this fund are closer to 2.8% per year, or double what Morningstar says.

The distribution costs of this fund are 0.30% and the transaction costs are an additional 1.1% per year. These additional fees shave 1.4% off the 10-year return, bringing the true return down closer to 5.8%. The difference between investing $100,000 for 10 years at a 5.8% annual return versus 7.2%, is approximately $56,000. Point being, it's worth the extra time to educate yourself on the true costs of investing. 

I’m not picking on mutual funds here but they provide a shining example of why net returns are so important. Make no mistake, you need to exercise this same exhaustive fee due diligence no matter if it’s a mutual fund, financial advisor or highly touted hedge fund you're considering. (For related reading, see: Due Diligence in 10 Easy Steps.)

The Bottom Line

While it may be fun being the person at the cocktail party who is “outperforming the market," it’s the person who is consistently earning excellent, risk adjusted returns, net of all fees and taxes, who is the real success story.

The answer to the most important question, along with some historical perspective, will allow you to manage your investment process using realistic measures of success that are much more likely to help you reach your financial goals than benchmarking.

(For more from this author, see: Check Current Economic Conditions Before Investing.)