Wealth Management or Returns? Part II
Higher Returns Do Not Instill Confidence
Today, I will do something more radical than the previous installment: challenge superior rates of return as a means to greater wealth by using the same scenario as the last article and described below.
Asset Value: $1 million
Time period: 20 years - 1/1/98 to 12/31/17
Cash Flow: $5,000 per month withdrawals
Investment Strategy: S & P 500 Index
Price Inflation Spending Adjustment: 2% per year
Taxes and Fees: None included
And as the first essay summarized the constant return vs. actual sequence hypotheticals, this one will feature the second two scenarios: reverse the actual sequence vs. superior management: 2 % per year outperformance.
That means the (arithmetic) mean return for the same 20-year period was a hypothetical 8.78%. Bear in mind, to outperform the benchmark for 20 consecutive years by a similar amount has never happened in a diversified portfolio. To do it net of fees is even far less likely, and with the same risk exposure is a matter of faith.
Given the assumptions above and reversing the sequence of actual returns, the investor’s account value at year end 2017 would have been $664,167. That is about $800,000 more than the actual results. Why does that matter? The timing of the investor’s cash flow expectations compared to the sequence of returns was far more favorable.
Specifically, they were withdrawing funds every year and the actual returns had three large negative results in the early years of the illustration and never able to recover. Conversely, large positive outcomes in the early years of the withdrawal phase of life provided a significant cushion for negative returns later in life when there is less money invested.
However, the large lesson is that this is impossible to predict and no one can control future market performance. But what about superior performance? What if you were able to outperform by a measly 2% per year with the same risk profile? Using the actual sequence of return data plus 2% each year, the ending value of this investor’s account was $508,016.
Certainly, that is a lot better than running out of money in year 18, but about $155,000 less than a 2% lower annual return with the reversed sequence. What does this prove? If you can fog a mirror, cash flow probably matters more than outperformance. And for confidence in achieving the important goals (tangible) and objectives (emotional payoff), that must be integrated with the reality of investment performance.
A summary of these four hypotheticals will be the subject of the next article in this series. And to learn more, please click:
https://www.amazon.com/Moneyball-Method-Middle-Class-Manifesto-Objective/dp/1696009111/