If you are planning for retirement, banking on rates of return to buoy your nest egg may not be your best bet.
Mike Miles, a fiduciary investment analyst for Variplan and Federal Times columnist, has found that average returns offer less predictive power than they might seem to. “You cannot determine which portfolio will produce the best results for you if all you know is the average rate of return,” he said, during a webcast that was part of Federal Times’ Thought Leadership Series. (You can view the webcast on-demand here.)
“The results depend entirely on the sequence of cash flows that you impose on the portfolio, how a sequence of withdrawals kind of fits together with a pattern on investment returns, from year-to-year, month-to-month, that the investment strategy you are using produces,” he said.
The problem, Miles said is that an average rate of return fails to account for market volatility or the impacts of withdrawals on the portfolio. So while rates of return can be predicted on a line, volatility could send actual performance results into what Miles calls a “probability fan.”
The probability fan takes the average rates of return of an investment strategy and projects the scope of both adverse and beneficial effects that could occur over a span of time. The range of those projections spread out from the rate of return, creating a “fan” of risk for the investor. The bigger the fan, the more uncertainty it creates for your investment.
Miles said that to truly balance fund performance over time, and shrink the fan, investors need to diversify by building a portfolio of balance that offsets losses in one investment with gains in another.
For investors looking to diversify their risk, Miles recommended looking into index funds, which provide a wider range of investment to minimize risk. Index funds, he said, will provide performance without the risk of having an adviser pick stock investments for you.
“Everybody who proposes to manage a portfolio for you by picking stocks as opposed to just buying the market, they say ‘If you pay me, I’ll pick stocks, and I’ll beat that index,” he said. “The problem is they are unlikely to do it.”
Ultimately, Miles said, investors can long buy and hold onto their plans without adjustment and expect to have the returns they would like for retirement.
“You make your decision entirely on where you are and where you need to be,” he said. “You plot out, if the market gives me what I expect, what should my portfolio be worth next year? Then you look and see if it is worth more or less. You see if it meets that expectation and respond by adjusting risk.”
