Our industry sometimes focuses too narrowly on rate of return. It makes sense when you consider that a percentage is the best way to compare how your investments are doing against the broader market, other investment strategies being deployed, or your friends at the water cooler. But we should remind ourselves that we don’t spend a percentage; we spend the account value. While an investor should certainly consider rate of return as a measure for how an investment is performing, one should also be aware of investment strategies that exist not solely to generate the highest rate of return, but rather are designed to result in the most spendable money in one’s life. After all, isn’t that why we’re doing this?
I’ve found the easiest way to explain this principle is to walk through a hypothetical example. Investor A has a traditionally invested $1,000,000 portfolio. If that account loses 10% in Year 1, the investor now has $900,000. Now, assume in Year 2 the investor has a +10% return. Even though that client’s average return over the first two years is 0% (-10% in year one, +10% in year two), their account would have recovered 10% on a lower number, and their account would end only at $990,000, down $10,000 from where they started. If you repeat that logic on Investor B with a down and up swing of only 5%, maybe because the investor had a strategy designed to manage the portfolio’s volatility, they would have dropped down to $950,000 after Year 1, and recovered back up to $997,500. Same average rate of return (both 0%), but the account with less volatility ends with more money (difference of $7,500).
Now, let’s compound that problem with the fact that the investor is withdrawing money. Imagine if after that first year drop, each investor needs to withdrawal $10,000. Investor A (our 10% scenario) only recovers back up to $979,000 where Investor B (5% scenario) ends at $987,000. You’ll notice that the difference between the two approaches widen when withdrawing. This is why, especially in situations where investors are withdrawing from an account, a portfolio with less volatility (and even a lower rate of return!) may end up with more money for that investor.
The moral of the story: While rate of return is important, it can sometimes mislead investors into chasing strategies that don’t fit their goals, and ultimately result in less money in their lives. Many people choose to engage an investment advisor to understand their rates of return relative to risk. Monitoring these facts over time can make for much more comfortable savers and retirees.