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How many of us have invested in a security, the market, or a product that is market driven expecting that 10% return we always hear about?
We’re always told that no matter how the market performs, it will consistently return 10% over the life of the market when you sum all of the averages.
Does this mean that if we buy in the market and wait 30 years, we’ll have a 10% gain on our portfolio if the market averages for those years equals 10%?
Not necessarily. Because in order to regain a loss in the market, you need an even greater gain. Welcome to "The Averages Problem."
For example:
Let’s say you have $10,000 in the market and it gains 20%. You’ll have $12,000, right?
Now let’s say the same market drops 20%. What does your $12,000 equal? It’s back down to $10,000, right?
No, it’s now at $9,600!
However, your portfolio report will say that you broke even with a 0% return because your 20% gain minus your 20% loss equaled an average net gain of 0%.
Then where is your $400?
Your actual return is really -2.02%!
| THE PROBLEM WITH AVERAGE RETURN |
| Amt. of Investment |
First Year Return |
End of Year Acct. Value |
Average Annual Return |
| Year 1 $10,000 |
20% |
$12,000 |
20% |
| Year 2 $12,000 |
-20% |
$9,600 |
0% |
| SO, WHERE IS YOUR $400? |
| Year 1 $10,000 |
-20% |
$8,000 |
-20% |
| Year 2 $8,000 |
20% |
$9,600 |
0% |
| AVERAGE RETURN IS 0% | ACTUAL RETURN IS -2.02% |
| Download a short summary of the Retirement Myth™ (PDF, 1.3 MB) |
| For illustrative purposes only. Not indicative of individual results. Assumes reinvestment of dividends and no effects of fees and taxes. |
Let’s extend this idea into Retirement Planning.
Most of us think that we can save our money, invest it into the market or a product that uses the market, and live off of 8-10% of our return (see table below) during our retirement years because we’ve been told that the market will produce an average return of 10%. We’ll be safe, right?
| Expected Returns (Starting Balance of $3,000,000) |
|
Market Return |
Account Value |
Account + Return |
Payments to Ourselves |
New Account Value |
| 1 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 2 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 3 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 4 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 5 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 6 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 7 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 8 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 9 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 10 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 11 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 12 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 13 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 14 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 15 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 16 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 17 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 18 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 19 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| 20 |
9.61% |
$3,000,000 |
$3,288,300 |
$288,300 |
$3,000,000 |
| For illustrative purposes only. Not indicative of individual results. Assumes reinvestment of dividends and no effects of fees and taxes. |
Not necessarily! To be safe, you should really only plan on taking 4% each year during retirement.
For example:
Let’s say you had a $3,000,000 nest-egg to live on during your retirement.
Most of us think, that we’ll be living in the lap of luxury by taking our 9.61% (approximately 10%) return from the market each year during retirement and living off of $300,000, right?
Wrong!
If we take hypothetical averages for the market for 20 years and use those against our $3,000,000 nest-egg, let’s see what happens when we take our $288,300 (9.61%) each year.
Actual Returns (Starting Balance of $3,000,000)
| Average Return: 9.61% |
Actual Return: 6.91% |
|
|
Market Return |
Account Value |
Account + Return |
Payments to Ourselves |
New Real Account Value |
| 1 |
16.50% |
$3,000,000 |
$3,495,000 |
$288,300 |
$3,206,700 |
| 2 |
12.40% |
$3,206,700 |
$3,604,331 |
$288,300 |
$3,316,031 |
| 3 |
-10.10% |
$3,316,031 |
$2,981,112 |
$288,300 |
$2,692,812 |
| 4 |
24.00% |
$2,692,812 |
$3,339,087 |
$288,300 |
$3,050,786 |
| 5 |
11.10% |
$3,050,786 |
$3,389,423 |
$288,300 |
$3,101,124 |
| 6 |
-8.50% |
$3,101,124 |
$2,837,528 |
$288,300 |
$2,549,228 |
| 7 |
3.90% |
$2,549,228 |
$2,648,647 |
$288,300 |
$2,360,348 |
| 8 |
14.30% |
$2,360,348 |
$2,697,877 |
$288,300 |
$2,409,578 |
| 9 |
19.00% |
$2,409,578 |
$2,867,397 |
$288,300 |
$2,579,098 |
| 10 |
-14.60% |
$2,579,098 |
$2,202,550 |
$288,300 |
$1,914,250 |
| 11 |
-26.50% |
$1,914,250 |
$1,406,974 |
$288,300 |
$1,118,673 |
| 12 |
37.20% |
$1,118,673 |
$1,534,820 |
$288,300 |
$1,246,520 |
| 13 |
24.00% |
$1,246,520 |
$1,545,685 |
$288,300 |
$1,257,385 |
| 14 |
-7.20% |
$1,257,385 |
$1,166,853 |
$288,300 |
$878,553 |
| 15 |
6.50% |
$878,553 |
$935,659 |
$288,300 |
$647,359 |
| 16 |
18.60% |
$647,359 |
$767,767 |
$288,300 |
$479,468 |
| 17 |
32.30% |
$479,468 |
$634,336 |
$288,300 |
$346,036 |
| 18 |
-5.00% |
$346,036 |
$328,734 |
$288,300 |
$40,434 |
| 19 |
21.50% |
$40,434 |
$49,127 |
$49,127 |
$0 |
| 20 |
22.80% |
$0 |
$0 |
$0 |
$0 |
| As you can see, you’ll run out of money in year 19 if you continue to pull 9.61%, or $288,300, every year. |
Annual Returns represent S&P 500 Stock Index annual returns from years 1964-1983. Source: National Underwriter.
The information above is being provided for hypothetical purposes only and is not intended to represent the actual results of any investment or account. |
What’s incredible is that the Average of the hypothetical Returns above actually comes out as a 10% gain over the 20 years. But once you realize that for every loss you need an even larger gain, you’ll see that the averages are misleading.
The Actual Return in this example is 6.91%.
Moreover, we didn’t even account for taxes in the above example.
When you add this factor as well (at an extremely modest 20% tax bracket), you’ll actually run out of money in year 15!!!
The above hypothetical example shows how averages are misleading, but it’s important to compare your situation against the real market and its returns.
| Most retirement calculators focus on saving for retirement and not on what comes after. And most use average rates of return to provide simplistic projections of portfolio performance. However, T. Rowe Price has an on-line calculator that helps determine the odds of a portfolio standing or folding under real-life projections. Be warned - some users may find the results from the T. Rowe Price calculator to be a cold dose of reality. But it’s better to learn what’s coming now, rather than later. |
 |
Averages Can Be Misleading
Lesson 1
The Choice Dilemma™
Are you making the right investment decisions by looking at market averages?
Lesson 2
The Glass Ceiling™
Find out how average vs. actual return can affect your retirement savings.
Lesson 3
The Retirement Myth™
Are you prepared to live off of only 4% of your retirement savings? You may have to.
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