Dollars and Averages are Misunderstood

averages

Fred wanted to invest some money and decided that an “average” return of 5% over time would be a reasonable expectation. After all, he was told that the “average” returns over the last 25 years was 6%, and he wanted to be conservative in his expectations.

So, when Fred thought about how $100 would average a 5% return over 3 years, he imagined:

          $100, $105, $110.25, $115.76…perfectly compounding at 5%

Fred invested his $100.  After 3 years his investment advisor told him he averaged a 5% return.  Fred thought, “Great, right on target!  That means I have $115.76, right?”  “Well,” his advisor squeamishly said, “Not quite.”  When Fred asked to see his annual numbers, he was shown these:

          $100, $160, $80, $84

‘WHAT?!?,” Fred gasped.  “You said I averaged 5%.  Where’s my $115.76?” 

“Uh,” his investment advisor said as he slithered out of his chair, “My secretary is calling me, hold on.”    

Well, Fred DID “average” 5%.  Here’s how:

          $100 went up 60% = $160

          $160 went down 50% = $80

          $80 went up 5% = $84

                    So, +60% – 50% + 5% = +15%, divided by 3 years = +5%.

                    There you have it:  5%!

And further, Fred learned a very important lesson: Averages” do not translate into actual dollar values.  However, they are regularly used by financial advisors to discuss historic performance and, in turn, calculate future projections.

Game over.  Whenever anyone tells you they average 5%, 10%, etc., it means absolutely nothing.  Nothing!  “Averages” are wildly misleading, disguise historic volatility, and ignore future volatility.

As a side note, what the financial advisor used as “returns” was actually “change”. And that, boys and girls, is standard practice.

All whole life insurance guarantees are based on the claims-paying ability of the insurer. Excess policy loans can result in termination of a policy. A policy that lapses or is surrendered can potentially result in tax consequences. Dividends reflect profits and are not guaranteed.

Volatility is So Not Your Friend

Volatility

Your financial advisor says, “Don’t look at your stock market portfolio every day.  It’s not good for your health.  Stocks always go up and down.  Rather, look at it once a year.” 

Really?  Just once a year?  Why would he say this?  Because even if you looked at it more frequently, you might not know what changes to make anyway.

Also, he knows that too many negative changes in your portfolio may make you nervous and even worse, want to change advisors! 

You’ll hear, “Don’t divert from your goal; volatility gives you the opportunity to buy low and sell high! The stock market will recover; it always does.”  Sound familiar?

Volatility is the HUGE elephant in the room.  It is defined as large swings in market price or value.  It is a major concern because it disturbs continuous cash growth. Volatility can take the values of our investments to insanely high levels and then crazy low levels, potentially all within a week.  Then we’d need to wait to recover.

But how long will that recovery take; do you have the time to wait?  And wait to recover to which level? The insanely high one you tasted for a day but didn’t sell because “It will go higher?”  Such stress and pressure we put on ourselves!

During the “accumulation phase” of your life, when you are building up your retirement account, volatility is severely damaging to continuous growth.  Regardless, we get used to the ups and downs, and we think we have time.  But drops in value require “recovery” over time. Some advisors would have us believe those drops in value are unavoidable, and not a big issue. Huh!

When we retire, we enter the “distribution phase”. Accumulation was tough, as we had to stomach losses and struggle to try to achieve desired results, and that was stressful enough. The distribution phase is even tougher; it is a part of our lives when we do not have the opportunity to continue working to put more money aside.

Imagine you are 82 and the value of your investments just dropped by 34%, as occurred in 2008.

How would you feel about that?  Would it affect your ability to pay your bills?  Would it cause undue stress?  Would it shorten your life?

“But your portfolio is averaging 5%!” your advisor claims.  Oh no!  That’s just another one of those poorly understood words, which makes you feel that your money is smoothly growing.  The problem is that it doesn’t smooth anything out; it just disguises the problem even further:  volatility destroys compounding and growth

If you would like to schedule a time to discuss your financial needs including volatility in your portfolio, we ask you to please take our “2 – Minute Survey” linked below. This will allow us to understand your needs and put you on the path to Financial Success. Upon completion of the survey, our team will follow up with you to review your specific Financial Goals.

Friends and family members that you refer to The Finance Fixer will receive a free copy of Pamela Yellen’s New York Times Best-Selling Book, “The Bank on Yourself Revolution” and her CD titled “How to Grow and Protect Your Wealth.”

All whole life insurance guarantees are based on the claims-paying ability of the insurer. Excess policy loans can result in termination of a policy. A policy that lapses or is surrendered can potentially result in tax consequences. Dividends reflect profits and are not guaranteed.

Question Conventional Math: Misused Words

Jack walks into his financial advisor’s office and asks how his portfolio is doing. “Well, says the advisor, you’re up 60%!”  A year later, in the same office, with the same question, Jack is told he’s down 50% for that 2nd year. Jack says “so +60% – 50% = 10%, divided by 2 (years) = 5% average return.  “Okay, not too bad…”

Sarah walks into her financial advisor’s office and asks how to best invest $100,000. The advisor suggests some investment opportunities and they examine one that looks interesting. To explain the value, the advisor says “Over the last 25 years, the average return of this has been 7.34%…so, looking forward, using 7.34%…wait, let’s be conservative and use 6.34%…so, in 30 years, you would have $632,265.78!” Sarah certainly liked that number.

Harry, a 22-year-old in his first job, is told that he is being automatically enrolled in the 401(k) program.  To encourage participation, the conversation goes like this: “How old are you? 22? When do you think you’ll retire? 65? Okay…43 years, and you’re going to contribute $212 per paycheck.  The stock market has returned 7% over the last 25 years, so, using that, at age 65 you’ll have over $1,300,000!  How does that sound?”  Harry was thrilled.

At the end of their projected time periods, 30 and 40 years respectively, their numbers fell far short.  Why?

Because of the misinterpretation and misuse of the words “average,” “change,” “return,” and “straight-line projections.”  They are deceptively utilized, especially with your hard-earned dollars. 

For example, in the first scenario, if Jack invests $100 and it goes up 60% in year one, he has $160.  If it goes down 50% in year two, he loses $80 (50% of $160 = $80). Therefore, Jack has just $80 left.  He may be up 5% on average, but his account value is down 20%!  Here, using the word “average” is completely misleading.  There is no direct correlation between an average over the years vs. the actual dollar amount left in your account.

In the next two scenarios, only straight-line projections are used (“if you get 6.34% every year…”).  Has there been any time when the market was up exactly 6.34% for even just 2 years in a row?  No.  There is a critical part missing to the equation:

Volatility of the markets. 

Ignoring volatility both historically and with future projections causes actual dollar results to fall far short of expectations.

Think of it this way:  If you retired with a $1,000,000 portfolio in December 2000 and took $40,000 each year (a 4% drawdown) to pay your bills, how would you have felt paying $40,000 in the year when the market tumbled 34% in 2008 and your portfolio was only worth $660,000?  Neither the “historical average” nor the “straight-line projection” would help pay those bills, would they?  How long would it take to get back to $1,000,000, if ever?

“Average,” “change,” “return,” “straight-line projections,” and “volatility” are all poorly understood, even by the pros.  More to come about each of these…

If you would like to schedule a time to discuss your financial needs we ask you to please take our “2 – Minute Survey” linked below. This will allow us to understand your needs and put you on the path to Financial Success. Upon completion of the survey, our team will follow up with you to review your specific Financial Goals.

Friends and family members that you refer to The Finance Fixer will receive a free copy of Pamela Yellen’s New York Times Best-Selling Book, “The Bank on Yourself Revolution” and her CD titled “How to Grow and Protect Your Wealth.”