Judging an investment based on its past average returns is a dangerous thing. It gives us a false sense of what the future might bring.
It is not just that ‘historical returns are not indicative of future performances’, the issue is about the sequence of returns.
This means that the ‘path’ you took will have a significant impact to your actual returns.
For example, you invested 3 years with the returns as such:
Year 1: +5%
Year 2: -15%
Year 3: +25%
Average return = 5% per year
If you have invested $1,000, you will get $1,116 at the end of the third year.
But this is lower than the $1,158 if you get a consistent 5% return each year.
This is why average return is misleading. Returns are dependent on the path you took.
This is also known as sequence of returns risk, which retirees have to pay most attention to.
Most people earn an income, save a portion and invest – Salary and savings become meaningful in the later part of the working life – 70% of total savings occurs in the final 10 years of retirement.
Let’s conceptually see how the sequence of returns changes your outcome.
Scenario A: Returns were flat in the early part of your investment journey and high in the later part.
Scenario B: Returns were high in the early part of your investment journey and flat in the later part.
You will end up with more money in Scenario A than in B. This is because you want the returns when your capital is sizeable, obviously, and the capital is only significant when you are near retirement. So you want a crazy bull run before the golden handshake.
The uncertainty continues to haunt you even after you leave your career and start drawing money when you retire.
The situation is now reverse because you have more capital at the start of your retirement and less capital as you draw it down over time. So you want strong returns when you just retire.
If you are unlucky and market returns are poor when you just retire, you suffer a double whammy for depleting your capital as you still need to withdraw to pay for living expenses.
But you realise it is beyond your control because you don’t get to choose when you get the capital and when the market is going to deliver the returns.
Luck plays a big role in investing too, not just in other aspects of your life.
One way to mitigate this is to reduce the luck element by going into steady investments nearing retirement. This is why investing is not always about getting the highest return and sometimes it is about limiting bad things from happening at the most crucial times of your life.