How Real Returns Get in the Way of a Good Plan
Projecting investment returns is a common and useful thing to do when planning for retirement or any long-range goal. Having a plan is important.
It’s just not always very realistic.
When talking about market returns, most online calculators and simulations use some given rate of return. Many times, the calculator will default to 8% or something similar. Lots of times, people will put in 10% (the commonly cited return for a stock portfolio). Out comes your result - you’ll have $5 Gazillion after 30 years.
But real markets don’t work that way. Some years they’re up, some they’re way down. Volatility is the neglected factor in most all online calculators. I decided to do a quick simulation of what the effect of volatility might be.
Below are two tables showing how $200 invested monthly compounds. The table on the left shows a steady 10% return. The table on the right uses actual historical S&P data. The difference in balances is shown in the cell in bold.
So we see that assuming a constant 10% return overstates the balance by $6,894. My point is that it’s important to understand the effect of volatility on a savings plan. The real market doesn’t return 10% (or any other percent) year after year.
August 14th, 2007 at 2:03 pm
Wow, I think this is a great point to get across, and very timely!
You did it in a very clean, concise way. Kudos!!
August 14th, 2007 at 4:48 pm
What a great point, and a nice post. I love it!
I love my ideas about my retirement calculations a little less now though. lol
August 14th, 2007 at 9:05 pm
Good point. A large amount of people don’t understand this point at all so it is a very good post that a lot of people should read. Both good returns, but the smooth return is certainly better.
August 19th, 2007 at 10:28 am
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August 20th, 2007 at 9:35 am
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August 20th, 2007 at 8:12 pm
[…] How Real Returns Get in the Way of a Good Plan @ Advanced Personal Finance: This is a good primer on how volatility impacts returns. […]
August 23rd, 2007 at 11:46 pm
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August 24th, 2007 at 10:02 am
This is a great help. Thanks for being so clear. I averaged the volatile side of your spreadsheet and came up with around 10%. Looks pretty much like what is regularly suggested by anyone talking about historical S&P. So, what do you do to work out this problem to come up with a more realistic number?
August 24th, 2007 at 11:05 am
Bonnie, you are 100% right. I made a mistake that I’ve now corrected.
August 24th, 2007 at 10:03 pm
This post gets my favorite vote for the week for sure. I have to echo Paidtwice and say that I too love my retirement projections a little less now.
Now I am trying to figure out how to come up with more realistic projections. Any thoughts? Thank you so much for this post. Very helpful.
August 27th, 2007 at 11:32 am
Bonnie, I didn’t intend for this post to be a downer for anybody! My intent wasn’t to mess up anyone’s plan, just illustrate the effect of volatility.
A projection that uses historical numbers is still probably valid as long as your time horizon is sufficiently long. Volatility really comes in to play right before retirement and in the first few years of retirement.
I’m sure your plan is just fine.
You’re way ahead just having a plan.
October 22nd, 2007 at 5:38 pm
10 years is a rather short period over which to evaluate the differences.
Also, one must look at the range of possible returns which is highly dependent on when the ups and downs occur in the time-frame.
I don’t get quite the same answers as posted for the investment value, but the relative differences between the actual and average values held true.
To look at the potential range of values, run the same model using the same 10 years of interest rates, but order the returns in lowest to highest and highest to lowest.
Ordering the returns from lowest to highest yields the highest possible final value, and you should find the value of the volatile to be rougly $30,000 higher than the “smooth” case.
Ordering the returns from highest to lowest yields the lowest possible final value, and you should find the value of the volatile to be rougly $15,000 lower than the “smooth” case.
The high and low potential values can be calculated this way over any time horizon. This still doesn’t change the fact that no matter what projection method is used, it will be wrong.
An overly simplified assessment of these numbers would be to assume that there is equal likelihood of any net asset value between the high and low at the end of the 10 year term. In that case, the expected, or average NAV in the volatile market would be expected to be (30,000-15000)/2 or $7500 MORE than the smooth projection.
I think that the best that one can do is to run many permutations of actual investment returns (over many different periods of time as well) and histogram the results (also known as running market simulations). You can then look at as optimistic or pessimistic a view as you desire, and compute a probability that you will achieve any desired set of results.
I.e. you will be able to say things like there’s a 90% probability that my investments will be worth at least $XXX in 10 years.