In this post, we examine how our investment planning returns (outcomes) can vary based on our investment experience and behavior.
Investment Planning and Investing on Average
When you hear the average return is 10%, what do you think you’re going to get in the next five years?
- 10%, 10%, 10%, 10%, 10%?
- 40%, 20%, 15%, -5%,-20%
- -20%, -5%, 15%, 20%, 40%
Set #1 is the most comforting. It is what we hope the future will hold. It simplifies planning. Unfortunately, people like Bernie Madoff use this desire for “steady but strong” returns to prey on his investors, as he knew they would rather see a single number versus variable returns. We never know what the future will hold, so why not show the most comforting scenario?
Investment Planning and Sequence of Returns
Set #2 starts exciting and gets disturbing. While the first year exceeded our expectations, it makes us think that something may be wrong with the strategy, as each year things get worse! Would you sell when your return went to -5% or -20%, or would you stick with the strategy?
Set #3 Whoa! You were expecting 10% and got -20%! Would you give this investment a second chance? If one day in the year was worse than the average for the year, would you have already dumped it? If you decided to hold on, would the -5% have made you feel good enough to stick around for another year? Keep in mind that things did get much better than the previous year.
Investor Behavior and Investment Expectations
What if someone had told you during the investment planning stages that your returns could be between +40 and -20? Would that affect your decision to start in the first place? Meaning the decision to stay invested when you got the -20%? I believe you should also question when your investment exceeds expectations. Say in this case, you got a 50% return. Most people would be thrilled! But you might be in a riskier portfolio than you want. That means you may also risk a -30% return. Your portfolio could change its balance if you don’t rebalance your portfolio to its original market risk allocation (the recipe).
Then too, your decision may even be impacted by the noise of the media, friends, and family! They sometimes give us various numbers and tell us what to think. I must say that I sometimes get sucked into listening to legions of “smart people” tell me how to read the daily news. Your friends may have heard from someone with insider information or who was right last year. When we don’t get the results we wanted or expected, that noise seems to be screaming in our ears!
Outcomes associated with 10% average returns over 5 years
Start Set 1 $100,000 Set 2 $100,000 Set 3 $100,000
Yr 1 10% $110,000 -20% $80,000 40% $140,000
Yr 2 10% $121,000 -5% $76,000 20% $168,000
Yr 3 10% $133,100 15% $87,400 15% $193,200
Yr 4 10% $146,410 20% $104,880 -5% $183,540
Yr 5 10% $161,051 40% $146,832 -20% $146,832
This is a hypothetical example and is not representative of any specific situation. So your own results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
In a perfect world, you would end up with more money with a straight-line return than the other two. However, more return has always come with more risk, so Scenario #1 is unlikely. The other two scenarios gave you the same ending value if you had stuck with it. But would you?
The Calm of Strategic Investment Planning
Since 1926, the US stock market has had its ups and downs. Modern financial strategies taught in the world’s top business schools teach the importance of diversification and asset allocation. Sticking with an investment plan vs. just jumping on the next, “what to invest in now” investment should help provide some calm during market storms.
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(1) The opinions in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested directly.
