Jan 222016
 

A few years ago, I finally took the time to better understand the potential impact of variable returns on investments. As you switch from being a saver to an investor you soon begin to recognize that the “average” return for a certificate of deposit or bond is quite different from the “average” return for a stock or mutual fund.

For an investment like a certificate of deposit, the stated rate will most likely work out to be about the average return. Over time it could be different depending on whether the interest is compounded and some other factors, but it will generally be quite close.

On the other hand, for equity’s averages like one year, three-year, five-year return etc., need to have more thought given to them, especially if you try to project them into the future. Standard Deviation is the factor typically used to identify the volatility of a past period’s average return. At most, all you can really say is that for that previous time period the average return was such and such and inter-period returns varied in such a way to indicate that typical range [within one standard deviation at least] was this.

This is why all of performance information comes with the caveat that past performance is no guarantee of future performance. In reality, the average return will change with each periodic measurement added or subtracted to the series as well as the standard deviation. As a result, no matter how much we want to project that number into the future, it really needs to be taken with a serious grain of salt.

Another consideration is sequence of returns. As the investment gets more volatile – think small cap stocks or international investments – the sequence of the returns have even more bearing on the final “average” return. This can be especially challenging for a retiree who is drawing down assets for retirement living expenses. In other words, a couple of really good years at the start of your retirement can make the rest pretty easy financially, but a couple of bad ones at the beginning can be devastating.

Intuitively this probably makes at least some sense, but to get a better handle on the actual impact of this, check out this chart Risk return asymmetry. Bottom line a 10% decline is probably manageable and relatively easily recovered. Declines any greater than that are potentially quite challenging for a retiree to overcome.

Let me know your thoughts.

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