Timing Matters in Rate of Return Assumptions

(Data taken from Investment News, “As dividends dwindle, it’ll take compounding longer to work its miracle” (P. 12, May 21, 2001).

From 1900 until now, the stock market has averaged a 10.8% annual return. As a result, conventional wisdom has been that investors will average around that 11% rate of return over time -- all they have to do is hold their diversified portfolio long enough. The reality is that to obtain that magic 11%, the timing of your returns has a major impact.

Take the poor guy who invested in the stock market index on September 6, 1929. To this day that investment has not reached an 11% compounded ACR. In fact, it took 58 years to reach 9% ACR. Are your clients ready to wait 58 years to get up to a 9% ACR?

Are you using an assumed linear rate of return? 11% for a basket of stocks, perhaps? Of 20 market peaks measured since 1900, it took an average of 18 years, 4 months for an investment made at the peak to reach an 11% ACR. Six times it has taken over 25 years including, as mentioned, the one case where it has not been reached after 71 years (see chart).

The point is, the timing of returns has a tremendous impact on the return, and the success, of an investment plan. If the markets are reaching peaks while you are investing, and then you stop adding new money to your investments (e.g., you’ve reached retirement), your return will be substantially lower over time than you think, even though the market as a whole is realizing higher returns. The converse is also true. If markets peak later, you will do better than you thought. There is simply no way to predict the peaks and valleys. To use a linear assumption of an average rate of return can mislead clients into making disastrous financial decisions.

It is also becoming increasingly difficult to rely on the smoothing effect of dividends. Dividend yields have averaged 4.51% since 1900, but are now down in the S&P 500 to an average of 1.25%. This implies “spikier” markets, taking us even further away from the fantasy of a straight-line projection. We do not know what the returns of the market will be, but we do know one thing, they will not be a straight line of identical returns for years on end.

The problem with assumptions is they often tend to take on the appearance of fact, when actually they are simply estimations that attempt to get an approximation of something in the future. When linear return assumptions are used, both the advisor and client know, intuitively and explicitly, that the result is incorrect; no market goes up the same amount every year. But to suggest it is “good enough” is belied by the facts, as illustrated above. A better way is to introduce realistic fluctuations in market performance to project future results.

Financeware uses three forecasting techniques to get at what the real chances of success are for a client. One, the wealth simulator, gives us a random view. And who has been able to prove that the markets do not behave randomly? Every time you think you have figured it out, you are humbled. The wealth simulator randomly assigns real historical market returns to a financial plan’s expected cash flows to see what the end result will be, success or failure. Now you can see how those peaks and valleys will impact your plan. This very randomness gives the client a better approximation of the real world, and allows an advisor and their client to more accurately assess market fluctuations on cash flows.