24 Jan 2020 High Returns Don’t Guarantee Wealth
Stock market returns last year as measured by the S&P 500 were a remarkable 31.5%. Gains this large are tempting. But return percentages can be misleading for several important reasons: Returns don’t necessarily correlate with improving wealth, returns come at a cost, and whole portfolio returns are generally lower than the reported market returns for very good reasons.
A common mistake investors make is to assume that higher returns generate greater wealth. This assumption is correct when a single investment is made at a point in time and left completely alone for a period of time. But most people either add to or spend from their portfolios and the timing of those additions or withdrawals relative to stock market swings can have significant impact on their wealth.
Take a look at this simple two-year scenario where returns of 12% and -6% are swapped. The average return in both cases is 3%, but when the client spends $1,000 from each portfolio, the resulting wealth is impacted unevenly. Spending $1,000 from a portfolio that just experienced a 12% gain results in $188 more in wealth than from a portfolio that just declined 6%.
The reverse is true when adding $1,000. Even though the returns are the same for both scenarios, wealth is unevenly impacted. Timing of cash flows matters, a lot. It’s why we continually test our client’s plans for adequate statistical confidence against thousands of timing variations.
Consider the following example in which we ran a hypothetical client lifetime plan invested in 60% stocks and 40% cash & bonds through three historical 38-year (planning lifetime) periods:
- Lifetime actual market return 8.5% (1954-1994): Broke at 87!
- Lifetime actual market return 9.8% (1960-1998): Broke at 90!
- Lifetime actual market return 7.5% (1940-1978): $2.5 Mil Estate
A focus on returns alone fails to address the single most important risk a life-long plan faces – the timing of market returns. Timing has a greater impact on the confidence of a life-long plan than does the amount of return. That’s why we spend so much time testing our clients’ plans for statistical confidence that they will meet or exceed their goals.
A second, closely related problem with a returns-focus it that of volatility, otherwise known as risk. The more volatile a thing is, the less predictable it is. Stock market volatility is hard on health and wealth, so why take more risk than is needed?
We often find that new clients are taking far more risk than is required. They marvel when they discover that the extra stock market exposure designed to provide more return, actually decreases the confidence that they will have sufficient wealth needed along the way to accomplish their goals.
Look at the chart below to see that this client’s confidence (Probability of Success) in the right-hand column actually decline as stock allocation is increased. The client’s Beacon 50 model portfolio has a 50% allocation to stocks and indicates an 89% probability, while the Beacon 100% stock portfolio is 7 points less at 82%. The risk impact on confidence can be significantly greater for clients who depend more heavily on their portfolios for income.
The third caution on return numbers is that they can be misleading. Few people would invest their life savings in the stock market alone, yet it’s the number that everyone talks about. Most take a portfolio approach to investing. Our Beacon portfolios, listed above, each have the same components, but in different proportions, allocated to provide the best return for a given amount of risk.
The components are US Stocks (Vanguard Total Stock Market), International Stocks (Vanguard FTSE All World) and US Treasurys (Barclay’s US Treasury 7-10 Yr). Each has a purpose in an efficient portfolio and each has a different return profile. Below is a Beacon 45 which is 45% stocks and 55% cash and Treasurys.
Notice that this client received the full measure of stock returns (Domestic Equities) at 30.6%, but the total return on the portfolio was a smaller 14.5%. That’s because the other 55% of the portfolio is invested in Cash which returned 1.97% and Fixed Income returning 6.42%, reducing the total or average return. This return information is presented for illustrative information only and past performance is not indicative of future results.
Because these clients are spending from their portfolio, our process points them to a lower volatility portfolio with more cash and bonds, which generally rise when stocks fall. Our process also objectively reveals that these clients do not need the higher returns of a heavily stock-weighted portfolio to confidently meet their goals.
Returns are and over-used measure for investment results, but the wealth those returns generate that is important. Having sufficient wealth to fund every goal you value, when you need it is what we focus on at Beacon. This is a good time to review your plan for accuracy, completeness, confidence and appropriate risk.