Almost all financial advisors and the financial media talk about average investment returns.
3-year average. 5-year average. 10-year average.
These are considered by many to be the best way to choose investments. Even though they’ll remind you that “past performance is no indication of future results.” That’s absolutely true, by the way.
Today, I’d like to spend a few minutes discussing the danger of focusing on average returns and highlight why year-to-year returns will have a much bigger impact on your dollar wealth.
I invite you to watch the video below, or scroll down to read the transcript.
Hey ladies, it’s Russ Thornton with wealthcareforwomen.com and today I’m going to talk a little bit about investment performance and the importance of the sequence or timing of the returns that you experience. Now, if you’ve read any of my writing on my website or in my newsletter or heard me speak before, you know that I will be the first to tell you that performance really isn’t that important and the reason why is it’s something that we can’t control.
Nevertheless, we don’t want to turn a blind eye to the impact in performance and the sequence a performance can have on your dollar wealth. That’s what I want to spend just a couple of minutes talking about today. If you could look at the following three investments, which would you choose? Now on the surface, this might look like a trick question because among the three investments they have the same average 10 year return and they all result in the same amount of dollars at the end of 10 years if you had started with 100 thousand dollars.
However, since today we’re talking about not just the average return that you experience, but the actual sequence of year to year returns that you experience with your investments. We want to look not just at the end results and the average, but the path that we took to achieve the end results. As you see here investment one, represented by the green line, actually starts out pretty strong and actually has a later downturn. Investment number three, represented by the blue line, has a slow, steady climb to the end result. Investment number two, signified by the red line, starts off weak but later performs pretty well and they all wind up with the same results.
The green investments, number one, starts with a bull market and later experiences a bear market. While investment number two in the red experiences a bear market and later a bull market, at the end of the 10 years they all tie. They all wound up with the same result. So why does this matter to you? Well it matters because very few people that I meet, very few women that I work with and get introduced to, have money that they invest and just leave alone for 10 or 15 or 20 or 25 years.
Typically, they’re either saving and adding money to it or in the instance where they’re perhaps retired, maybe they need some of this money to supplement their retirement income, so maybe they’re pulling money out of their investment plan over time. Let’s see the impact of a different investment plan and how that could impact this. Instead of taking 100 thousand dollars and not adding or withdrawing any money from it, what if we were actually adding 10 thousand dollars a year, over the 10 ten years and use the same three investments that we looked at earlier. What would the results be?
Interestingly, because of the sequence or the timing of returns one of the investments, number two in this case, winds up with almost twice the amount of money as investments two and does quite a bit better than investment three in this instance. The reason for that is if you’re adding money over time, investment number one in the green started out strong, but after several years after you had contributed or accumulated more money when it did experience a bear market there was more money already invested and as a result the bear market took more of a financial toll.
The flip side of that is with the red or number two investment, we experienced the bear market early and so when you’re adding more money and the market is not really performing you’re actually accumulating more principal. In the event that the market performs better later, you’ve got more capital invested and therefore the bull market has a greater effect on your dollar wealth.
In this case, number two would be the winning investment, of course we would only know that in hindsight. Let’s look at the flip side of that. Instead of adding money every year, what if you had 100 thousand dollars in an investment pool, let’s say a private foundation and we wanted to pull out 15 thousand dollars per year to fund charitable goals. Could you do that for a full 10 years without depleting all of the money?
Similar to the last example we looked at, in this instance we’re actually pulling money out every year to the tune of 15 thousand dollars a year. In this case investment number one, in the green, does better. If 100 thousand dollars is the starting amount of dollars, the principal, and we want to make sure we don’t run out of money over 10 years while still sustaining these 15 thousand dollar annual withdrawals. Number one is the clear winner. Whereas numbers three and number two run out of money actually pretty quickly and are not able to sustain the withdrawals or the original principal.
Why is that? It’s kind of the reverse of the situation we looked at earlier. If we’re pulling money out, it’s ideally better to pull money out while the market is rising. In this case, in investment number one, with the green, if it experienced a positive or bull market earlier and we’re withdrawing money, it has less of an impact on the dollar wealth than if we experience a bear market later.
If on the other hand, in the example of number two, signified by the red line, if we experience a bear market and on top of that are having to withdrawal 15 thousand dollars a year that just exacerbates the downward pressure on the investment principal. Even if we were to experience a bull market later, we have potentially already drained or depleted the investment enough where really no amount or no significance of a bull market is going to be enough to get us back to or above the starting principal.
In this instance, number one wins. So what’s the moral of the story? Well again, as I said earlier, performance is not that important because it’s not something that we can control, it’s not something we can predict. While there are many people out there that are all too happy to tell you that they think they know what the markets going to do, they think they know how to time the market or to pick investments and can jump in and out. I would argue that they’re either lying to themselves, lying to you or maybe both. Be very wary of people that think their crystal ball works better than everyone else’s out there.
Here’s a summary table. In this first line you can say if we invest 100 thousand dollars, don’t add or subtract any money, leave it alone for 10 years, we wind up with the same dollar amount. Again, because the average return was the same. If we’re saving 10 thousand dollars a year as we demonstrated earlier in the chart, investment number two is the clear winner. If we’re withdrawing 15 thousand dollars a year, investment one is the clear winner. While they all produce the same average return over a 10 year period, the actual sequence of returns that your investment experiences and the impact of withdrawals or contributions to the investment over time, will have a meaningful impact on your dollar results.
Remember, we can’t spend percentage returns. It’s nice to talk about average returns, but at the end of the day they’re really not that important, because you can’t go down to the grocery store and spend your average return. You can only spend dollars. The point I would love to leave you with today is when you receive a return is just as or perhaps more important than the average return over time. Markets are going to go up, markets are going go down. When they happen and how severe they happen is completely unpredictable.
What’s the solution? If the future is unpredictable, if we can’t plan for or predict the timing of returns but we recognize that it’s important, how do we plan around that? With Wealthcare For Women and the approach that I apply in my work with women like you, we actually do a lot of stress testing. We use some complex math and calculations to actually stress test and run thousands of simulations to look at what were to happen if we had a sequence of events where we have good markets, bad markets, great markets, worse markets than we’ve ever experienced and then everything in between.
We run one thousand simulations of your life to look at the impact of the sequence of those returns and how that impacts your ability to achieve your goals and maintain your lifestyle, live your best life and achieve the things that are important to you. At the end of the day, we can’t control performance. It’s not something that is that important, but there are things we can control and that’s where I think we should focus our time and attention. We can control our risk, our taxes, our fees, your goals in terms of your timing of when you retire or when you want to achieve other goals, how much you save, how much you spend.
Furthermore, this is not a set it and forget it approach. We need to consistently monitor, adjust, make course corrections, because things are going to happen. You’ll experience changes in your life, we’ll inevitably experience changes in the market and with that in mind we need to have a process in place to monitor and make the necessary adjustments when they’re necessary to make sure we keep you on track.
With all that in mind, again, performance is not important in and of itself, average returns aren’t important. The sequence of or when you experience returns can be critically important and you need to have a system or process in place to test and take the impact of those sequence and returns into account when you’re making both short and long term financial planning decisions for you and for those that you care about.
If you have any questions, you can reach me at wealthcareforwomen.com. My name is Russ Thornton and thanks for tuning in today.
Just like the sentence above says . . . if you have questions or would like to discuss this idea or anything else, please give me a call or send me an email. Or you’re welcome to leave a comment below.
To better understand the nature and scope of the advisory services and business practices of Wealthcare Capital Management, Inc., please review our SEC Form ADV Part 2a, which is available here. Past performance is not a guide to future returns. Before acting on any analysis, advice or recommendation in the above content, you should seek the personalized advice of legal, tax or investment professionals. By selecting the links in the above email, you may be redirected to third party websites not under the supervision of Wealthcare who may have different privacy policies than Wealthcare.