Managing the expectations clients have for their investment portfolios can be more challenging than actually managing the portfolios themselves. There are at least two important elements in this tango: clients having reasonable expectations, and portfolio performance that hovers around those reasonable expectations.

Bull market periods create one of the greatest challenges when it comes to developing reasonable expectations. Unusually high rates of return can set expectations that are both unrealistic and unachievable over the long term.

For instance, during the exuberant period from 1989 to 1998, the S&P 500 had an average annualized return of 19.2%. But the average 10-year rolling return of the S&P 500 over the 41-year period from 1970 to 2010 was 11.8%.

The returns of 1989 to 1998 were quite a departure from the long-term reality. Sadly, investor expectations are upwardly mobile - even when such expectations prove to be clearly unrealistic.

High expectations lead to performance chasing. As advisors know, investors late to the game get burned.

For example, latecomers to the tech party of the 1990s got creamed in 2000, 2001 and 2002. By the end of 1999, Cisco Systems had a five-year average annualized return of 93.9%.

A $10,000 investment in Cisco at the beginning of 1995 was worth more than $274,000 by the end of 1999. These were the returns of watercooler heroes at the office. Others listening in envy decided to get in on the action.

In 2000, Cisco Systems sank 28.6%. The next year, Cisco plunged 52.7%. In 2002, Cisco crumbled another 27.7%.

By the end of 2002, a $10,000 investment at the beginning of 2000 was worth just $2,442. During this period, Cisco stockholders lost an average of 37.5% annually. Both the boom of 1995 to 1999 and the bust of 2000 to 2002 produced performance that created unrealistic expectations on both ends of the spectrum.

WHAT'S REASONABLE?

Unrealistic upside expectations are hard to manage, which means clients face a high probability of being disappointed even if their portfolios deliver what would otherwise be deemed acceptable performance. Basically, their portfolios are doing fine, it's their expectations that are messed up. Conversely, after a ugly bear market, it can be difficult for investors to remember that investments actually can produce gains.

What is a reasonable expectation? Let's start by taking that average 10-year rolling return of the S&P 500 since 1970, 11.8%. (Bear with me even if you don't believe that's a reasonable performance expectation.)

Consider how often a 100% equity-based investment portfolio like the S&P 500 delivers performance close to 11.8%. To measure this, we've chosen upside and downside performance bands of 500 basis points. These bands create an upside performance limit of 16.8% and a downside performance limit of 6.8%.

OUTSIDE THE MEAN

As shown in the "Out of Bounds" chart, an all-equity investment portfolio was outside of the 500 basis point limit in 13 of the 32 rolling 10-year periods, or 41% of the time. Of course, in recent years, the rolling 10-year returns have been dramatically lower than 11.8%. This is the type of downside performance volatility that can rattle even the most resolute investor.

Let's also consider the rolling 10-year performance of a multi-asset portfolio that includes seven equally weighted portions of large-cap U.S. equity, small-cap U.S. equity, non-U.S. equity, real estate, commodities, bonds and cash (see "Hugging the Mean" chart,). A diversified portfolio rebalanced annually generated a mean 10-year rolling return of 11.5% - very close to the 11.8% mean of the S&P 500.

Equally important is the consistency of the 10-year rolling returns. In only 9% of the periods (three out of 32) were the portfolio returns outside the 500 basis point bands. Most notably, they never exceeded the upside limit and, only in recent years, did they slightly exceed the downside limit.

That means a well-diversified portfolio that includes both equity and fixed-income assets produced returns comparable to a 100% equity portfolio. However, the level of consistency was significantly better than an all-equity portfolio.

MANAGING EXPECTATIONS

Of course, there is a trade-off when building a diversified portfolio. You'll notice that the multi-asset portfolio never had 10-year annualized returns near 20% that the 100% large-cap U.S. stock portfolio generated in the late 1990s.

For some investors, missing the upside can be as painful as experiencing the downside. This is where client education can create the right type of expectations. When building a diversified, multi-asset portfolio for a client, it is vital to be clear that the performance benchmark is not the S&P 500, even though it's cited as the practically official return of the stock market.

The S&P 500 is a perfectly acceptable index for a client with a 100% large-cap U.S. stock portfolio. But client portfolios almost always include other assets, so it's crucial to identify an appropriate benchmark that's congruent with the portfolios they are building and that an advisor and a client can use as a yardstick to measure portfolio performance.

Having a multi-asset investment strategy and the courage to stick with it during up and down markets is a characteristic of successful investing. Long-term investors learn that portfolios ultimately regress to their mean, particularly as an investment holding period lengthens. For equity portfolios, that mean return is around 10% (for periods of 20-plus years).

But as history has shown, 100% equity portfolios incur significant performance variation around the mean return over shorter time frames, such as 10-year rolling periods. It is precisely that variation that can lead otherwise logical investors to behave badly, namely selling at lows and buying at highs.

Conversely, investment portfolios that are broadly diversified generate returns that are consistently closer to the expected mean. When investor expectations remain reasonable, benchmark indexes are appropriate and portfolio performance is less volatile because of broad diversification, the intricate tango between advisors and clients can be an enjoyable dance.

Craig L. Israelsen, Ph.D., an associate professor at Brigham Young University, is the author of 7Twelve: A Diversified Investment Portfolio with a Plan. Megan Howell is an undergraduate student at BYU.