And How It Could Wipe You Out!!!
If you (or your financial advisor) use financial planning software to help you make financial decisions you’re almost guaranteed and doomed to failure!
Let me explain. All of these programs let you plug in how much money you have now, how much you’re saving, when you want to retire, how much you spend in retirement. Then they combine that with an assumed life expectancy and an “assumed average annual return”.
Let’s say you plug in a 10% assumed average annual return. About the only thing I can guarantee you is, you’ll never make an exact 10% return year in and year out. The real world reality is, some years you’ll make money, other years you’ll lose money. Rarely will you ever make an exact 10% return!
In over 20+ years my observation with all the clients we’ve worked with is that they’re spending dollars, not percentage returns. So it’s very easy to make a huge mistake.
Assuming a higher average return will produce more dollars. This is NOT always true!!!
Here’s what I’m talking about.
Look at the chart below. It shows two different accounts. One with a 5% average annual return, the other with a 10% average annual return, both withdraw the same amount of money from the account every year. So on the surface, you’d think the 10% average annual return account would be the better account. Not true!
|
Year
|
Return in %
|
Return in $
|
Contribution
(Withdrawal) |
Portfolio Value
|
Year
|
Return in %
|
Return in $
|
Contribution
(Withdrawal) |
Portfolio Value
|
|
$100
|
$100
|
||||||||
|
1
|
0%
|
$0
|
-$7
|
$93
|
1
|
-21%
|
-$21
|
-$7
|
$72
|
|
2
|
24%
|
$22
|
-$7
|
$108
|
2
|
-9%
|
-$6
|
-$7
|
$59
|
|
3
|
19%
|
$21
|
-$7
|
$122
|
3
|
-1%
|
-$1
|
-$7
|
$51
|
|
4
|
21%
|
$26
|
-$7
|
$140
|
4
|
26%
|
$13
|
-$7
|
$57
|
|
5
|
8%
|
$11
|
-$7
|
$145
|
5
|
14%
|
$8
|
-$7
|
$58
|
|
6
|
4%
|
$6
|
-$7
|
$144
|
6
|
17%
|
$10
|
-$7
|
$61
|
|
7
|
2%
|
$3
|
-$7
|
$139
|
7
|
22%
|
$13
|
-$7
|
$68
|
|
8
|
-4%
|
-$6
|
-$7
|
$127
|
8
|
16%
|
$11
|
-$7
|
$71
|
|
9
|
-8%
|
-$10
|
-$7
|
$110
|
9
|
13%
|
$9
|
-$7
|
$74
|
|
10
|
-12%
|
-$13
|
-$7
|
$90
|
10
|
18%
|
$13
|
-$7
|
$80
|
|
5%
|
average
|
10%
|
average
|
As you can see, the account that only gave you a 5% annualized return over the last 10 years actually gives you more money at the end of 10 years!
It’s all based on the yearly return and when it occurred in the account.
Did you know (most advisors don’t) there are tools available that allow you to run not 1or 2 spreadsheets, but literally a thousand spreadsheet analyses. Each one mixing up the yearly returns, both the amount of the return (profit or loss) as well as the order they are received. This gives you a much better picture of how realistic your financial projections and goals are, given all the uncertainty the financial markets have in store for us.
The technical name for these tools is Monte Carlo Simulation Analysis. If you (or your advisor) aren’t familiar with and using these tools, find an advisor who is……Now!
Bottom Line: I want you to understand that your average annual return is not important. The important factor is the return you receive each year, and the order they occur!
Never Make Financial Planning Decisions Based On Average Annual Return Projections!
