Building trust with clients starts with clear communication. Jargon-filled conversations can leave your clients confused and unsure about their investment decisions. This blog seeks to help you simplify investment discussions by focusing on two key concepts: capture ratios and historical annualized returns (CAGR).
UNDERSTANDING PERFORMANCE: CAPTURE RATIOS IN ACTION
Capture ratios are a straightforward way to explain how investments perform in different market conditions. They include two types: the upside capture ratio and the downside capture ratio.
Upside Capture Ratio measures how well an investment performs relative to a benchmark during periods when that benchmark has risen. For example, if a benchmark rises by 10% and the investment rises by 12%, the upside capture ratio is 120%. This indicates that the investment gains more than the market in positive conditions.
Downside Capture Ratio shows how an investment performs relative to the benchmark during periods when the benchmark has dropped. If the benchmark falls by 10% and the investment falls by 8%, the downside capture ratio is 80%. This means the investment loses less than the market in negative conditions.
When meeting with a client, you might say:
"Let's look at how these investments have performed relative to the market. For the periods when the market was up, our selected investment had an upside capture ratio of 110%, meaning it not only kept pace but exceeded market growth by 10%. During downturns, its downside capture ratio was 90%, indicating it held up better than the market, which decreased more. Over the last five years, this investment has grown at a consistent compound rate of 10% per year, turning every $10,000 invested into just over $16,000, regardless of market ups and downs."
These ratios help clients understand the balance between risk and reward, as they highlight the potential for both growth and protection against losses in simpler terms.
BEYOND AVERAGES: UNVEILING THE MARKET'S ROLLERCOASTER
We often hear about "average" returns, like the stock market averaging 10% annually. This "average" (CAGR) can sound reassuring, but it doesn't tell the whole story.
The market doesn't move in a straight line. To reach that 10% average, there were likely periods of exhilarating highs (20% or more growth) followed by stretches of flat or even gut-wrenching negative returns. CAGR simply smooths out those bumps over a specific timeframe.
For example, you might explain:
"Consider an investment that has an average CAGR of 8% over 10 years. While this number might suggest steady growth, the reality of investing is seldom so linear. During this period, the best rolling 5-year CAGR might have been as high as 15%, reflecting a particularly strong market. Conversely, the worst 5-year period might have shown a CAGR of just 2%, or even negative returns, during tougher economic times."
Key Point: Expect Ups and Downs, Not Serenity
The crucial message for your clients? Periods of negative or low returns are a normal part of investing and could potentially occur again during the time your clients invest with you. If that low number makes your client uncomfortable, it's a sign they might need a more conservative investment approach that prioritizes stability over high-risk, high-reward scenarios.
Transparency is key…
Hopefully, this blog equips you to have impactful conversations with your clients:
Focus on capture ratios: Utilize capture ratios to explain how investments perform in different market conditions.
Embrace realistic returns: Discuss historical worst-case scenarios (low CAGR) and ask if your client is comfortable with that level of volatility. By setting expectations and highlighting potential downturns, you empower them to make informed decisions based on their risk tolerance.
By framing the conversation with capture ratios and realistic historical returns, your clients can make informed decisions based on their risk tolerance. Transparency is key! Exploring the full range of historical returns, including low points, helps create realistic investment plans and well-informed clients, less likely to be surprised by future market fluctuations. This collaborative approach fosters trust and empowers your clients to invest with confidence.