Mean… median… mode… dispersion… reversion to the mean…
Are you asleep yet?
For those who don’t like math, I understand that equations and computations can take on the appearance of nothing more than squiggles on a page, a seemingly endless drawing with little rhyme or reason.
Fair enough. Not everyone is mathematically inclined.
Unfortunately, everyone has responsibility for funding their retirement, and it is here that math can be your friend or your foe.
The good news is that the concepts involved are simple… the bad news is that many – including those who are supposed “experts” – screw it up all the time. The problem, you see, is understanding average versus sequence…
A common refrain in the world of investment self-help is to advise investors that over the long haul stock markets go up and the U.S. markets earn around 8% (on average).
Well, obviously if the U.S. markets earn an average of 8%, then they MUST be going up, or else the long-run average would be zero or less than zero. So let’s focus on this concept of average.
The notion of average is simple. Add up all the data points and then divide by the number of data points.
If the city of Tampa gets just over 36.5 inches of rain in a year (365 days), then the average rain fall per day is 0.1 inches.
But does this mean that every single day the people in Tampa should expect 0.1 inches of rain? Of course not. This is where sequence shows up.
While 36.5 inches of rain does fall in a year, only 100 days have rain. More importantly, the rainy days tend to be clustered in the June-October time frame.
If a person was expecting 0.1 inches of rain every day, then he might never turn on his sprinkler system and all of his grass and flowers would wither and die in the months between November and May.
Obviously this is a bad idea if you want to enjoy a healthy garden. It’s also a bad idea if you want a healthy portfolio. If you expected a certain percentage return every year, your portfolio will quickly turn to dust.
While the long-run average return of the U.S. stock markets has been around 8%, that in no way guarantees a return of 8% every year. It is entirely possible that an investor can experience very high returns early in their growth investment years (say, the 1990s) and low or even negative returns near the end of their growth investment years (like the late 2000s).
The timing of the returns becomes everything.
If high returns are earned early on, then investors feel more confident as they watch their portfolios explode to the upside. They start to feel richer and plan for a more comfortable retirement.
Then, when the down years hit near the end, the investor is faced with a double whammy. Not only are the bad years draining his retirement account, but the number of years left to work and make up the losses is dwindling.
The solution is to understand that average is important, but sequence – the order in which returns are earned – is paramount.
This requires investors to understand and forecast what lies ahead. It’s hard, but it can help investors save a lifetime of accumulated assets.
Think about those who were on the cusp of retirement in 2007, 2008 and even 2009. If they were relying on market averages to see them through, then they most likely left their retirement accounts exposed to great risk near the end of their working careers.
As the markets cratered, investors in this situation saw their IRAs, 401ks and other accounts lose value by the minute.
While the “average” told them to expect 8%, the sequence led to massive losses just when they could not afford it.
Knowing the importance of sequence, you should examine exactly how much risk you are taking and what potentially lies ahead. With the global economy clearly in slowdown mode, now is not the time to be taking risk, especially if you can’t afford sequential years of low or negative returns.
Besides… who wants to be average?
P.S. Any half-decent retirement savings plan should have constant streams of income as a key component. Now, there are several places and ways to find such streams – and this is something we keep a look out for as we scour the markets in search of opportunities for you – but perhaps one of the safest and easiest is high-yielding accounts. And EverBank has just such an account for Survive & Prosper subscribers. It’s called the High Yield Checking Account and you can click here for the details.
Ahead of the Curve with Adam O’Dell
Post The Long and Short Sequence of Investors Returns Announcement
The sequence of investment returns can impact lifestyles of long-term investors and retirees. But sequence is equally important during shorter timeframes.