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COVID-19 has brought unwanted drops in the value of many people’ s retirement account balances. Some people had a similar experience during the Great Recession of 2008 and 2009. If you are like most people, you do not like seeing your balance up one day and then significantly down the next. Some ups and down are to be expected, but is there a way to avoid big fluctuations? The short answer is no, but understanding different types of returns may help you avoid some of the bigger ups and downs.
Often when people are making investment choices, they do so based upon historical investment returns. Typically, they are presented with a great deal of information, including returns for the last three months, one year, three years, five years, 10 years and since inception. But what does it all mean? And does any of it indicate a greater accumulation of investment returns on top of savings?
If you’re saving for a future goal, then the accumulated balance will be more important to you than the investment returns alone. This article will show you that volatility is likely more important than your investment returns. In fact, the biggest threat to growing your retirement balance is volatility, i.e., the market’s up and down movement, or variance.
Consider the hypothetical chart above that illustrates both return and volatility. Let’s assume our investor makes an initial deposit of $100,000 and makes no further additions. Now, let’s look at scenarios of “flat returns,” a portfolio with little volatility and one with higher returns and higher volatility.
In Year 1, we see what we likely would expect from each. The “flat return” returns 10%, the “lower volatility” portfolio returns 30% and the “higher return and higher volatility” portfolio returns 43%. The highest balance, $143,000, comes from the latter. It is $33,000 more than the “flat return” account and $13,000 more than the “lower volatility” portfolio. You may even be saying, “I’m glad I picked the financial advisor that got me 43% versus the one that got me 10% or the one that returned 30%.”
The next year, even though both the “lower volatility” and “higher volatility” decreased in return, they are still significantly higher than our “flat return” of 10%. However, seeing the return decrease by 20 percentage points in the “lower volatility” and 30 percentage points in the “higher volatility” may have you scratching your head or wondering what might happen next.
In Year 3, as you might have feared, the “lower volatility” portfolio decreased to a -10% return and the “higher volatility” to a -23%. That means the “flat return” portfolio produced the highest balance. In fact, the “higher return and higher volatility” portfolio is now in third place. Hopefully, seeing those reduced returns did not cause you to jump ship and look for a new investment or sell everything to cash and wait out this negative time.
In Year 4, the portfolios rebounded and now the “higher return and higher volatility” portfolio is once again the highest return. However, if we skip to the sixth year, we see that our “flat return” is once again in first place and the “higher return and higher volatility” is once again in third place. Now skipping down to the Year 11, we see that the “flat return” is once again in first place and our “higher return and higher volatility” portfolio is not keeping pace with either of the other two.
Which rate of return are you tracking?
From an average return perspective, the “flat return” portfolio average is 10%, as you would expect. The “lower volatility” portfolio average is 10% as well. However, it’s easy to see that the ride was quite a bit bumpier than for the “flat return” account. The “higher return and higher volatility” portfolio had a higher return by 1.36 percentage points, yet that did not help the accumulated balance. Before this exercise if I had told you that the average return on your investment would be 11.36%, would you have guessed that your account balance would’ve been lower than the balance for a 10% flat rate average return?
From an annualized rate of return perspective, we see a different story. The “flat return” continues to be 10%, but for the others, the volatility shows up in this year by year rate of return. In the annualized return, we are looking at the actual returns generated rather than the average return. And we can see that the “higher return and higher volatility” portfolio balance was lower by than 10% compared to our “flat return” portfolio.
Before you Google “flat return” portfolios, please note that the last time an investment advisor was able to deliver that, it was deemed a Ponzi scheme run by Bernie Madoff.
If you’re like most investors, you react to your accumulated value rather than the average rate of return, annualized rate of return, or standard deviation. (Simply put, standard deviation is a measure of variance. It says that if you take the average return and add the ± standard deviation, you will find that two thirds of the time the returns fall within that number.)
Takeaway
When looking at investment returns, it is important to know what kind of rate of return you’re looking at. Are these average or annualized rates? What is the standard deviation? While not always a perfect predictor of the future, at least this information will give you some idea of what to expect. What’s most important is that you keep focused on your end goal, not your rate of return. You’re looking for an accumulated balance that achieves your goal. Rather than chase returns, you will be better off focusing on the steps you can control to accumulating the balance you need for a comfortable retirement.
Footnote
This chart was a collaborative effort with Chuck Self, Chief Investment Officer of iSectors. This data does not directly reflect any specific portfolio strategy, nor is this an endorsement of the use of any iSectors investment strategies.
