Today I want to talk to you about a fairy tale that is told to a lot of people. The fairy tale math of average annual rate of return.
Now, I’m going to spend a good amount of time talking about when the average annual rate of return is used poorly or in ways that misrepresent, but I do need to say there is a time and place for using the average annual rate of return and that is when you’re doing projections overtime to set approximate, but flawed, figures.
The bottom line I tell clients is this: If you’re ever being sold a financial product that you are going to rely on to provide your future income and that sales pitch, brochure, or whatever is based on a non-guaranteed average annual rate of return you need to get out of that office.
If you’re ever being sold a financial plan and see a non-guaranteed average annual rate of return is used to show you how much money you will leave your kids, you need to get out of that office.
If non-guaranteed average annual rates of return are anything other than background calculations to approximate the wisdom of certain decisions you need to run and I’ll tell you why.
Here is a prime illustration of how I can deceive you with an average annual rate of return. Let’s say you give me $100 to invest and in the first year I do great, I double your money! I get you that 100% return on your money, so now your $100 is $200!
Man, you’re bragging to me about all your friends, you’re inviting me out on golf trips, I’m the king of the world to you – Midas in the flesh! The second year, though, is down. 50% loss. At the beginning of the year, you had $200 and you lost 50% so now you’re back to $100.
By the way, do you see how I unconsciously switched from talking about me when times were good to talk about you when money was down? Funny how the brain does that, huh? Anyway, you’re not so good with me, you’re pretty upset, and for good reason. But the first year was so good I’m able to reassure you a little bit and you stick with me.
In that third year, your loyalty pays off! That third year I err…we get 100% return all over again! I’m back baby! You high-five me, give me a little bit of a punch in the arm for the stress I caused you in year 2, but I’ve doubled your money again, so you give me a look like DeNiro in Analyze This, “You, you’re good you.”
Then year four comes along. I’ve lost half again. You’re down to $100 after my 50% loss. After that, you’re sick of me. You pull your money out. You get your $100 back.
So – after four years of investment, starting with $100, ending with $100, what is your average annual rate of return? It has to be 0% right? It has to be! You started with $100 and ended with $100. No win, no loss. But that’s not how the math works when I’m putting my marketing campaign together! Let’s look at it a little deeper.
Year 1 I have you at 100% return, Year 2 I have you at a 50% loss, Year 3 100% return, Year 4 50% loss. Let’s take those numbers. You have four numbers +100,-50,+100, and -50. So 100 – 50 + 100 – 50 = 100. Divide that by the number of years you had invested with me to average out your return. 100 / 4 = 25. Know what number is going on in my next email blast? 25%! I’m rightfully and legally put on all the advertising that I got you a 25% average annual rate of return!
One day a co-worker of yours comes into my office and says, “Well if you got that for him why did he pull his money?” I’ll just mumble something about how some people are just so ungrateful and never really happy. That I’m glad to get that pain in the ass out of my office anyway. Your co-worker will think maybe that’s true and put down $200!
Isn’t it funny how this math works? By the way, this math is assuming that I haven’t charged you any fees! That I was doing this work for free, which you know is not going to happen!
Get it? Do you get why you need to watch out for the average annual rate of return? It does funky things. The only thing that matters to me in investing is a sequence of returns. In fact, when it comes to retirement planning specifically, the numbers that I would guarantee myself solid returns for would be the decade surrounding my retirement date.
You can take the actual same actual return numbers over a period of time and shuffle them up in any order and what you will find is that if you have gained at the beginning of your retirement and losses at the end you will be better off than if you see those same gains at the end of retirement and the same losses at the beginning.
This can sound counterintuitive, but it is all too true when you’re using your assets for your retirement income. When you use assets for income during a losing year, that money no longer exists in the market to rebound when the market comes back. Instead of saying, “OK I lost ‘X’, I need to make about 1.5 or 2X to get that back this year,”
You need to calculate that you’re losing 7%, taking out an extra $60,000 for your income needs plus another $8,000 to pay the additional income tax. So you are down 7% plus you have $68,000 that’s no longer going to be there to help get back that 7% loss. On a $1m IRA, your need for income in retirement turns a 7% loss into a 13.8% loss and changes the gain you need to make up that loss before you need income again from 7.5% to 16%!
And by the way, this math gets worse the smaller your account is! If you had a $100,000 account rather than a $1m account, with the same income need your need for income would now require a 300% return to follow the 7% loss rather than the 7.5% return. Once again, people with less are carrying extra risk than those with more.
To me, that means you need to be out of any market where you bear the risk of loss for the money you’re going to be using for your retirement income. If you have extra money above and beyond that, that is fine. Do what you want with it. Ride the roller coaster.
Have something to brag to your friends about. But if you need money for income, you cannot afford to take a risk with it. That’s it! You cannot afford to take a risk with the money you need to eat!
I cannot say that strongly enough. Unfortunately, there are too many marketing machines out there that hand out Aesop’s unknown tome “Average Annual Rate of Return and Other Fiscal Fairy Tales” to sell you on their vision for your money.
This vision has you bearing the risk of loss, and them probably getting fees all along the way.