This post continues a series of thoughts on investment returns and misleading aspects of average annual returns. The articles started with my Tacoma News Tribune column June 4 and extended to include this post about cost basis returns.
Here, we look at how the sequence of investment returns becomes much more important when an investor has shifted to withdrawing assets rather than accumulating a retirement nest egg.
When you are accumulating assets, the order of annual returns doesn’t matter. Take the S&P 500 return of the past 10 years and apply it to an investment in any order you like.
|
2003 |
28.50% |
2008 |
-37.02% |
|
2004 |
10.74% |
2009 |
26.49% |
|
2005 |
4.77% |
2010 |
14.91% |
|
2006 |
15.64% |
2011 |
1.97% |
|
2007 |
5.39% |
2012 |
15.82% |
For example, if you start with $500,000 and apply the annual returns in sequential order, reverse order or any random mix, you will end 2012 with a balance of $982,188.30.
However, you cannot use the average annual return over this period and get the same result. The average annual return over this 10-year period is 8.72%. If you apply annual 8.72% compounded growth to the initial $500,000 you would have an ending balance of $1,153,624 – a positive difference of $171,436.
If you evaluate an investment by reviewing the average annual return, you can be easily led astray of reality. Even more problematic, if you apply an average annual return assumption to a retirement income projection, you could receive wildly misguided output.
The order of returns becomes much more important in the withdrawal years.
Consider this variation of the earlier example.
Start with a nest egg balance of $500,000 and take out $25,000 (5%) at the start of each year. For simplicity’s sake we won’t consider adjusting the withdrawals upward each year to offset inflation. Since you need the $25,000 for year one, the balance left invested is $475,000.
If we use the average annual return assumption, the balance at the end of 2012 is $721,159. Even though we removed $25,000 per year ($250,000 total), our ending balance increased nicely due to the assumed 8.72% annual return that was achieved from 2003-2012.
Now, not only is the average annual return misleading, but the sequence of those returns becomes important. If we do the math with the actual order that was experienced, at the end of 2012, the account balance is $611,575 – almost $110,000 less.
If we reverse the order of returns, the ending balance is $565,801.
What if we move that ugly -37.02% return from 2008 up to the first year of the assumed retirement (2003 in this case)? Even though the average return over the 10-year period remains the same, the order is detrimental to long-term financial security. After 10 years, the account balance has dropped to $440,976 – 39% less than the projected balance if simply applying the average annual return each year.
| Return sequence A | Return sequence B | Return sequence C | Return sequence D |
| 8.72% return each year | Actual order of S&P 500 returns 2003-2012 | Reverse order of S&P 500 returns 2003-2012 | Negative return first (2008’s -37.02 switches places with 2003 return) |
| End balance | End balance | End balance | End balance |
| $721,159 | $611,575 | $565,801 | $440,976 |
Stretch these examples out over 20+ years – more reflective of a full retirement – and you will see that even if you achieve the same average annual return over time, it’s possible that one order of returns could run out of money while a different sequence could more than offset the annual withdrawals with exceptional growth.
KEY TAKEAWAYS
- Average annual returns are not a good proxy for the actual investor experience.
- Using retirement calculators that rely on a simple average annual return assumption can be problematic. It’s important to use sophisticated enough analysis to generate many variations of return patterns. This way you can understand a range of possible asset projections and determine a probability that your money will last longer than you do.
- This example uses an investment only in the S&P 500 Index of large U.S. stocks. It is not a globally diversified portfolio and is not reflective of an investment strategy that we would recommend, either while accumulating assets or withdrawing from them.
- A globally diversified portfolio may have lower returns over time but also could be expected to experience less downside risk. This type of portfolio would not be expected to continue growing at the rate demonstrated here while withdrawals were also being made.
Have you determined how much money you’ll need to retire without too much concern about the impact of market returns?
How have you projected future account growth and the impact of withdrawals?
~ Gary Brooks, CFP® — Brooks, Hughes & Jones, Partners in Wealth Management – Tacoma, WA
Forward to a friend
Stock market rally justified by earnings, reasonable market value
The U.S. stock market turned in a strong first month of 2013 as the S&P 500 gained 5.2%.
This coming after a 16% total return for the S&P 500 in 2012 has some wondering if the rally is close to exhaustion.
While we don’t expect double-digit gains to build throughout 2013, we don’t think the market is close to being overheated either. We’re not making a forecast but thought it might be helpful to see a couple charts that help explain value of the market. Of course, these charts and analysis portray a rational view and markets can become irrational from time to time. There’s no sense in trying to predict a return for the year or any short time frame. As Warren Buffett has said: “short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also grown-ups who behave in the market like children.” However, we can confidently forecast that you’ll want stock market exposure over long periods regardless of short-term results.
So on with the show.
Two charts from presentations I’ve watched recently demonstrate how market prices may have room to grow to catch up with the reported earnings of U.S. companies.
This view of S&P 500 inflection points is from J.P. Morgan. Look at the first peak, March 2000. A measure of market value is the price/earnings ratio of the market. What price are investors paying for each dollar of company earnings. At this euphoric time, the P/E ratio (based on forward earnings expectations) was over 25. It had become excessive and the market needed a cleansing to get back down to a P/E ratio closer to historic norms.
The recovery from the internet bubble peaked in October 2007. At that time, even though the price of the S&P 500 had surpassed the March 2000 price, the price/earnings ratio was 15.2, 40% below the 2000 P/E ratio. The market had not been bid up by speculative investors quite like in 2000. Of course, that didn’t stop a significant bear market due to the credit crisis and recession of 2008.
So where are we at today? The recovering S&P 500 has crossed a price of 1,500 again. But corporate earnings have also grown at a strong rate. This means the price is generally justified by the earnings. The forward price/earnings ratio at the end of 2012 was just 12.5, roughly half of the irrational exuberance peak of March 2000.
Add January’s price appreciation and the forward P/E ratio is about 13.3.
The combination of earnings and investor confidence in the trajectory of those earnings will be critical to determining how long this rally will continue.
Here’s another view – from economist Fritz Meyer – demonstrating how the market price has some catching up to do if history can be trusted as a guide.
The black line of the S&P 500 price over the past 25 years has generally kept an edge above the red line (S&P 500 earnings). It’s clear to see however, that the late 1990s S&P 500 value and the 2007 value grew disconnected from the reality of earnings.
Since 2010, though, good corporate earnings have not been reflected in stock prices that grow at the same pace. The S&P 500 black line has spent most of the time below the earnings line. Look at projected earnings going forward for 2013 and 2014 and you could rightfully judge that there is justification for stock prices to continue growing without getting too expensive.
Recovering investor confidence could have something to do with that. If cash flows shift back toward stocks and away from the bond market, gains may continue.
Of course, there are many potential shocks to the global economy which could erode emerging confidence and disrupt the growth in corporate earnings. But at this point, even significantly lower earnings would justify the current value of the S&P 500.
The S&P 500 is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as determined by Standard & Poor’s.
~ Gary Brooks, CFP® – Brooks, Hughes & Jones – Partners in Wealth Management – Tacoma, WA
www.BHJadvisors.com
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Tagged earnings, investments, market valuation, s&P 500, stock market, stocks