Averages Are Not Your Friend

Have you ever looked at your account statement and wondered why the average return of the underlying investment is higher than the return you received? Before we get into this analysis, please know we will not factor into this equation any investment management fees or the time value of money. We simply want to know if an investment has an average return of 8%, is it safe to assume your account will increase by 8%.

Consider this 5-year segment of performance:

                              +10%                 -32%                  +40%                 +12%                 +10%

Add those together and divide by 5 to get the average annual rate of return.

 40 / 5  =  8% annual average

Now, apply this same market performance to a $1,000 investment.

Year 1                $1000.00 + $100.00 (+10%) = $1100.00

         Year 2                $1100.00 –  $352.00 (-32%) =  $  748.00

Year 3                  $748.00 + $299.20 (+40%) = $1047.20

Year 4                $1047.20 + $125.66 (+12%) = $1172.86

Year 5                $1172.86 + $117.29 (+10%) = $1290.15

This segment of market performance increased the $1,000 investment by $290.15.

($290.15/$1000) x 100 = 29.01% / 5yrs = 5.8% average annual rate of return.

The investment averaged 8% but the investor only received 5.8%.

The future Value of variable products cannot be accurately projected.

When you meet with a Financial Advisor to create a retirement plan, you will discuss your goal, risk tolerance, and time frame. You may say something like, “I want to retire in 25 years with $1M and I am ok with a moderate degree of portfolio risk. The advisor will then use financial planning software to determine that if you save $1,200/month for the next 25 years and average an 8% return you will reach your goal.  But there is one problem. ALL retirement planning software is flawed. It is designed to “stack” the assumed rate of return each year to arrive at a future value. The problem with this is that the stock markets do NOT go straight up yet the financial planning software never allows for a single down year. And if they redesigned the software to allow for down years, how much should they go down and when should those down years occur? We can’t answer this question because markets are unpredictable. You think this isn’t a big deal but you might want to think again.

Below is a 5-year projection of an 8% stacked return.

Year 1                $1,000.00 + $ 80.00 = $1,080.00

Year 2                $1,080.00 + $ 86.40 = $1,166.40

Year 3                $1,166.40 + $ 93.31 = $1,259.71

Year 4                $1,259.71 + $100.78 = $1,360.49

Year 5                $1,360.49 + $108.84 = $1,469.33

This software suggests that if you invest $1,000 and average 8%, in 5 years you will have $1,469.33. But wait. We already did a 5-year projection of $1,000 earning an average of 8% above. It was worth $1,290.15 after 5 years.

$1,290.15 – ($1,469.33) = -($179.18) a shortage of 17.92%

If you followed the advice of your financial advisor, you would be short 17.92%. This shortage is over only 5 years. Can you imagine how short you would be over 25 years? Unfortunately, your retirement projection is not worth the paper it is written on because you cannot accurately predict the future value of a variable product. Note: a variable product is any investment that is invested directly in the stock market and includes bond funds.

What I have discussed in this article is called “Sequence of Return Risk”. It is a very real and serious threat to your financial and retirement success. If you’re like me and prefer guarantees, go to JondaKnows.com/resources and select “Guaranteed Income” to learn more.

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