Wealth Management or Returns? Part I
Percent Returns Do Not Instill Confidence
When investing money for short-term needs or long-term goals, the highest possible return at the best risk level seems like a good idea. However, returns are impossible to know as you think further into the future and have cash flow needs that require more than high quality fixed income securities can deliver.
On top of that, fixed income may be subject to income taxes and monetary inflation that add risk. Bear in mind, those risks are imposed by the whims of government. And that’s on top of the additional market volatility imposed by regulation.
Regardless of anyone’s opinion about market efficiency, the future performance of capital markets is uncertain. No one can predict or control rates of return – and only a return manager would try.
Besides, that can backfire – as the next essay will demonstrate, but let’s begin with my book’s Introduction: Moneyball has since become known for statistical analysis, risk management and profitability in professional sports. And for us, profitability is living with confidence and risk management knowing your risk capacity, but the remainder of this piece is statistical analysis. The assumptions here are the essentials:
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
The average annualized return was 6.78% during the twenty years above. For the actual return for each of the twenty calendar years and the actual dollar results, please refer to Chapter Six of my book that includes these four illustrations:
Constant rate of return projection – 6.78% (arithmetic mean)
Actual variable return sequence
Reverse actual variable return sequence
Market outperformance actual variable return sequence – 2% per year
Given these assumptions and a constant rate of return projection known as deterministic assumptions, the investor’s account value at year end 2017 would have been $821,433. That is almost $180,000 less than what they started with, but it’s more than zero. Why does that matter? Because if this investor completed all of their withdrawals as scheduled and invested as illustrated, the actual account value at year end 2017 would have been negative $138,316. That’s a swing of almost $1 million.
But not really. They would have been at zero two years earlier. Clearly, the actual sequence of returns is a significant risk and constant return projections can be disastrous. However, what if there had been no withdrawals? The results would have been the same as the constant return projections.
What does this prove? If you can fog a mirror, cash flow probably matters. To further illustrate, the reverse return sequence and outperformance return sequence will be the subject of the next installment in this series. And to learn more, please click:
https://www.amazon.com/Moneyball-Method-Middle-Class-Manifesto-Objective/dp/1696009111/