Money

Why is Order of Rate of Return so Important

This post may contain affiliate links. Please read my disclosure for more info.

Why Order of Rate of Return so Important - MakeLivingGoodRecently I came across an interview of Tony Robbins. During the interview he mentioned something which caught my attention. He illustrated a hypothetical scenario of someone having his life’s savings invested in stock market through a 401K or IRA plan and as soon as person turns 65, the stock market turned red and fall into a multi-years of bear market. In this scenario, how will lifetime savings of this person look like? How will the multi years of stock market’s fluctuating rate of return impact this person’s portfolio and life ahead?

To answer these questions, I decided to do some analysis of this hypothetical scenario. I believe, this can happen to anyone on the day one of his or her retirement. Although its hypothetical scenario, but markets do go up and down, and crashes do happen from time to time as we saw two major market crashes in short period from 2000 to 2009.

The goal of this study is to understand the effects of a “sequence” of rate of returns on someone’s life savings. In other words, if stock market crashes in first few years of retirement and then goes up for next few years, how would it impact a portfolio? So, let’s get started.

Meet Joe Black

Mr Joe Black is our imaginary character who has saved consistently throughout his life. Every time Joe was getting a paycheck, he was automatically keeping aside 20% of the paycheck into a 401K or IRA account. As Joe always wanted to retire rich, so he carefully allocated majority of his retirement portfolio in funds yielding high rate of return. He also made good amount of profits from stock market investments via IRA account. This is what I call double whammy on tax returns. Using this strategy, Joe had accumulated over $500,000 by the age of 65 years old.

By the way, you can have both accounts 401k and IRA at a time. Here’s an interesting book (update: another one) which helped me understand why its wiser to have both the accounts.

With half a million dollars portfolio, Joe is pretty confident to live a good life after retirement. His plan is to stay invested in stock market to earn maximum rate of return over time and grow his portfolio enough to support his living expenses up to age 90 and beyond.

Before we proceed with study, let’s look at how much would Joe really need to maintain his current lifestyle. This we can relate to ourselves as well to calculate the magic number to retire early.

Maintaining Lifestyle

Many people struggle to estimate how much money they would really need to maintain same lifestyle after they retire. To answer this question for yourself, check out detailed post on how to get financial freedom. In case of Joe, I will keep it simple. How much money does Joe need now to live comfortably? Is it $3000, $4000, $6000 a month? He would at least need that much of money when he retires.

Now conservative ones would argue that what about inflation. I got you and I agree that we should consider effect of inflation in our estimations. At 2.5% inflation and $3500 living cost as of today in USA, someone will need $6,475 a month or $77,700 a year to maintain same life style in 25 years. But your expenses will also reduce to some extent after reaching retirement age. For instance, your children might start earning as well so you won’t have to support them. But on other hand there could be health related expenses which might put pressure of monthly withdrawals.

For simplicity sake; we can assume that Joe needs to withdraw $40,000 a year from his retirement account. He would get another $40,000 per year from his social security account. So in total he would have $80,000 a year after retirement which is under his requirement of $77,700 a year.

Here are few ways to build wealth:

Since keeping $500,000 in cash in a checking bank account will not earn any rate of return, Joe decided to stay invested in stock market to keep earning good rate of return and maintain his lifestyle using dividends earned from his investments and occasional trading or selling part of his investments. Although many stock brokers offer anywhere from $4.95 per trade to $20 per trade, there’s an excellent stock broker service that I personally like and use extensively which offers $0 trades for any size portfolio. So, practically it’s totally free service and its also one of the best out there today. I highly recommend it.

You might like:   100 Love Messages to Honor Your Lost Husband and Keep His Memory Alive

Next lets move to the next level of our scenario and look at two hypothetical scenarios which might happen to Joe.

Multi-Year of Bear Market

Now imagine that as soon as Joe retired, the stock market tumbled and went into heavy declines for next few years before finally turning green. If this continues until Joe turns 90 years old, how would his half a million dollar portfolio look like?

Let us run these numbers to see that now.

Effect of Rate of Return when Market goes down - MakeLivingGood

As we noticed, Joe might be devastated from this. He worked so hard throughout his life and accumulated good amount of savings but finally when it was his time to enjoy the hard-earned money, the stock market didn’t favor him. In just 10 years after his retirement, Joe’s lifetime savings will vanish. In fact by age 68, just 3 years after his retirement, Joe would lose about 60% of his portfolio to the turmoil of the market and his regular living expenses. How would someone’s life be in such a situation? Disheartening.

Multi-Year of Bull Market

Now imagine an opposite scenario. In this case, instead of going in bear market (market closing in losses); it actually went up. This would certainly work in favor of anyone who is invested in the stock market, especially ones who are into index funds.

Let’s run the numbers again but this time, we will reverse the order of market’s rate of return from previous scenario. Here’s the outcome.

Effect of Rate of Return when Market goes UP - MakeLivingGood

This is quite astonishing. These numbers actually made me write this post. Just by reversing the order of market returns from previous scenario, the results turned excellently in Joe’s favor. In this scenario, Joe would not only live happily for until age 90; but he would still have another $253,422 left in his account. This is a dream scenario for all of us.

I spent lots of time thinking, what Joe could do to be in a scenario#2 and not in scenario#1. My conclusion was he couldn’t control market movements. Nobody can. Although he could move his portfolio into some safer investments (more on this later) but even in that case his portfolio wouldn’t survive for long considering low-interest rates as of today. Over long-term,  stock market investment tops any other investment as proved by history.

What Really Happened Here

The key takeaway from this post is;

The sequence of returns on an investment are as much as important as rate of returns are.

It can  make a portfolio or ruin it forever. But why?

Let me explain with an example.

Suppose you started with $100 of portfolio. If you lost 50% of this by next year, you would be left with only $50 in your portfolio. In order to go back to $100 again, you will need 100% return (not 50% that was originally lost).

I recommend you to read it again if it’s confusing and think about it for a minute. Most investors do not understand this simple math and think what if they lost 30-40% of their investment in a stock. It takes much more to get back to where you were before the loss.

You lost 50% of the original portfolio. In dollar terms you lost $50 and left with a portfolio of just $50. To get back to $100, you need to earn $50 which is double of what you have ($50). That is why you need 100% return.

Even if you lost 30% and at $70. In order to get back to $100 again, you will need 43% return.

This is why Warren Buffet has these 2 golden rules:

Rule – 1 : Do not lose money.

Rule – 2 : Do not forget Rule number 1.

I have found that all successful investors follow these rules very strictly with their investments. Never lose money because they know its way too harder and takes a very long time to get back to the point they were before the loss.

How to Safeguard an Investment

If Joe wants to safeguard his investment from market crashes, then what are his options? Before we get into few safe heaven options, I warn you that there’s no 100% guarantee on any kind of investments. There’s always some risk involved with any sort of investment. Let’s explore few options now:

Remember: Knowledge is the Power in Investing World

Hold in Cash

The obvious choice to protect ourselves from market fluctuations is to sell all portfolio and hold its value in cash. In this case, we won’t be impacted by market’s crashes or busts. So, one would think what could be the risk involved in this case. There’s a risk of theft if you keep huge sums of money at home ( like under the mattress ). But who would do it, right? Many people still keep large amounts of money at their homes.

You might like:   Easy Money - How I Made $5,088 from Credit Cards without Top Cashback

What about banks? No doubt our money must be safe in banks. Is it really? Just to refresh your memory, during 2008 financial crash many banks and financial institutions were shut down. Although US government provides a guarantee on money stored in our bank accounts if bank is approved by FDIC. Even though there’s a limit of $250,000 to $500,000 per customer, you might not get whole amount back in case the bank defaults if you had higher balance in the account.

Another killer for cash is inflation. It’s a silent killer and steals our cash’s value over time without us seeing it doing on daily basis. But over the time period, one would definitely see how expensive things get with time. Thats the impact of inflation. What a $1000 could buy back in 1970s would need $14000 to buy same stuff. I recommend you to check this out to know more about it.

Government Bonds

In addition to paying nominal interest rates, government bonds also come up with a guarantee to pay on maturity date. What could be wrong with that, right?

Well, a guarantee is as good as the ability of the guarantor to pay it back.

History has shown that governments and countries defaulted on their debts time to time in last 200 years. Below is the table that I found on wikipedia:

Countries defaulted on debt payments - MakeLivingGood

Source: Wikipedia

The list is very long (much more than I thought) and whats concerning is that we can clearly see almost all major countries in that list. If governments can default on their debts, how secure are the government bonds that we are planning to buy with our life’s savings? It is still rare but who had thought about the great financial crisis in 2008-09.

Buy Annuities

Annuities are kind of insurance on income and there are various types of annuities. For instance; fixed annuities, indexed annuities and variable annuities. As their names suggest, they offer different rates of returns and come with varying levels of risks throughout their tenure.

According to my best knowledge, no major insurance company has failed even during 2008 financial market meltdown. But I am not a financial planner to recommend you to buy annuities but it’s certainly something that is appealing to me as of now.

The way an annuity works is as follows:

You turn over a sum of money (lump sum or over a period)  to an insurance company and in return the insurer agrees to pay you a guaranteed amount each month for the rest of your life. If you’d like the payment to continue as long as either you or your spouse or partner is alive, you can choose the “joint-and-survivor” option. The amount of the payment you receive depends on such factors as the amount you invest, your age and the level of interest rates.

There are few caveats as well with annuities. Such as, you could invest your savings on your own or with help of a financial advisor to do it for you and generate earnings probably more than an annuity pays. And if you take this approach you’ll have full access to all of your money all of the time. You can sell your entire investment whenever you want or need in future unlike annuities where you have no control over where your money is invested.

But there are two things an annuity can offer that we can’t get by investing on our own self.

  1. One is a guarantee that we will receive our payments no matter how long we live and no matter how the financial markets perform in future. Sure, we can invest cautiously on our own, but there’s still the chance we could run out of our savings if our investments perform poorly or if we live well beyond our life expectancy. In other words, we are buying peace of mind with annuities.
  2. The second thing an annuity can do is provide a higher level of lifetime income than we can’t generate investing on our own at a given level of risk. That’s because of something called “mortality credits.” Some people who buy annuities will die sooner than others. As a result, insurers are effectively able to transfer the money that would have gone to those who died early to those who will die later. Thats effectively how annuities guarantees a lifetime payment.
You might like:   Healthy Lifestyle for Happiness

Here are some annuity plans offered in US;

Guaranteed Income for Life - Annuities - MakeLivingGood

source: barrons

Deferred income Annuities - MakeLivingGood

source: barrons

As we can see, there are many types of annuities with different benefits plans. There’s no single plan that fits all the needs. So, if you are interested in one, then I recommend you to consult a fiduciary advisor and prefer to go for deferred income annuity which gives better income. Once the income starts, that remains fixed at that level. So, in my opinion; starting early in life would provide better returns.

I also learned that some 401K plans can be converted into annuity plans. If you have built a good lump sum amount in 401K plan, then may be you can convert it into an annuity plan in a tax deferred manner and let your investment grow faster. But do not buy annuity plan within your 401K plan because that’s counter productive and would provide lower returns.

[Update] Remember annuities provide low returns if we just compare them with other investments. But like I mentioned, someone who is buying annuities isn’t buying it for its returns but peace of mind and a guaranteed income for rest of life. Another thing I found with some of the annuities plan is that as you age, the returns get better. So, if you are already near your retirement age, you might be able to get 7-8% return on your investment in annuities. Another approach a younger person can take is to invest his/her money in some index funds or equivalent investments which yield higher returns through 401K account and then after retirement, the funds can be moved to an annuity with 7-8% returns which should give good recurring income for rest of the life. I personally like this approach.

Here’s a good source to learn more about annuities.

What would the rockefellers do - MakeLivingGood.com

Diversify

The ultimate master of asset allocation in history is Ray Dalio. Ray is the founder of the largest hedge fund on the planet with over $160 Billion in assets. In last 30 years, the fund managed by Ray has lost only 4 times with maximum loss of 3.95%. Remember this includes the time period of major crashes like dotcom bubble (2000s) and housing bubble (2008). While everyone was losing money by over 50%, Ray Dalio made 40% returns in 2010.

His strategy is to create an all season portfolio which works in all types of markets. According to him, controlling and minimizing risk is the most important job of an investor. As Warren Buffet also said, do not lose money; Ray successfully implemented it.

According to All Season Portfolio, Ray recommends to invest 30% in equities as they are three times more riskier than government bonds. Rest 70% must be divided into treasury bonds, inflation linked bonds and corporate bonds. As far as rate of return generated from this strategy in last 30 years is concerned, then Ray have beaten the market in long-term by great margins using this strategy. Since 1991, he produced 21% compounded annual rate of return which is far more than what major indexes made. Considering the great rate of return and minimal risk involved in his strategy, I think this is something we NEED to think about seriously and may be applied it with our own life’s savings.

You can read more about Ray’s strategy here.

Principles by Ray Dalio - MakeLivingGood.com

Closing Thoughts

You, me or any group of people can not predict the movement of markets accurately or control it. As we saw in this study that order of rate of return has great impact on our portfolios. It can make or damage a portfolio in no time. What are our options to minimize the loss? I personally liked Ray Dalio’s approach on building all season portfolio. We (regular investors) might not be able to build an all season portfolio as good as Ray, but by applying few of his principles, we can minimize the downside to our portfolio while still earning a decent rate of return over long period of time. I highly recommend you to read more about it here. Finally let me finish this post by saying –

Preserving principle is more important in any investment than earning high rate of return.

Let us know your thoughts on how do you protect yourself against losses in retirement fund.

You have finished reading:

Why is Order of Rate of Return so Important

Dont Quit - Push Yourself to the Limits - MakeLivingGood

Follow us on Pinterest for more awesome articles and tips

GET INSPIRED VIA EMAIL


Leave a Reply

Your email address will not be published. Required fields are marked *