Savings, Investment, Risk, and Rate of Return
Investing is Not the Same Thing as Saving
Since the advent of the “Qualified Plan” (401K, IRA, etc), there has been a dangerous shift in the use of language regarding how we prepare for the future. The most misleading and possibly damaging term in personal finance is the Retirement “Savings” Plan.
Make no mistake, qualified plans are investment accounts, not savings accounts. Money you put into a qualified plan is subject to the risks of the market.
Allow me to restate it: If there is risk, it is not saving.
The definition of risk: To expose (someone or something valued) to danger, harm, or loss
For whatever reason, the conventional way of looking at investment risk is the opposite of the definition of risk! It is said that, especially when we are young, we should take on “more risk for more reward” – with the insinuation focused on the “reward” part. The thought goes that since we are young, we have more time to to play the long game of the market, recover any losses, and come out with larger gains in the end.
However, what is not considered is the huge, very likely, opportunity cost of a loss incurred at a young age.
Think of it like this: compound interest becomes exponentially more powerful the longer you allow it to grow. The exact same thing happens with the opportunity cost of a loss, but in reverse. It’s the money that never had the chance to grow over time, because it was lost in the early stages.
“Average Rate of Return”
Another very misleading term relating to retirement “savings” is the concept of “average rate of return.” We often hear an S&P 500 Index Fund will return a “safe 8% average rate of return.” While this is mathematically true, what is often not understood is that this is not the same as earning 8% every year.
You can have a positive average rate of return and still lose money!
This is because once you experience a loss, you will forever-more lose out on the accrual of the amount lost.
Look at another example of an initial $10,000 investment compounding at 8% every year. For one year only, in year 5, the account experiences a 5% loss. That single year loss of 5% causes the 30 year value of the account to decrease by 12%. In order to make up for the 5% loss in year 5, the account has to experience a return of 23% the following year in order to get back on track and come out even at the end of 30 years.
To crystallize this idea even further, lets look at some actual market data. Below is a comparison of the “Average Rate of Return” for the S&P 500 (including dividends), over 30 years, from 1987-2016. The average rate of return during that time was 11.53%. Let’s compare that to the same initial investment earning an actual 11.53% every year:
As you can see, earning an “average rate of return” of 11.53% is not the same as earning 11.53% year-over-year. With real market data we end up with about $85,000, or 30%, less than what was projected using “average rates of return.” The unfortunate truth is that most people, including many financial planners, do not understand how this works.
The problem with this is that when people make their retirement plans, they are using the projections from the chart on the right instead of the chart on the left. What will happen when they reach retirement age and have 30% less money in their retirement “savings” than what was planned?
The real rate of return, the Compound Annual Growth Rate, of the above example is 10.1%. You may be thinking to yourself that 10.1% is still a great return! I would agree if that was the only thing to consider. However, in addition to the serious issue of projected returns vs actual returns, we also have to take into consideration the timing of the market. Will the market be where you want it to be at the time when you need the money?
Let’s take one more look at the “average rate of return” on real market data. For this example, we will go back in time to the first 20 years of the S&P 500.
The above shows a 4% average rate of return for the first 20 years of the S&P 500. Yet at the end of that 20 year period, the value of the account was the same as when it started! To be fair this illustration took place from 1930 – 1951, during the Great Depression. However, there is no reason to think this couldn’t happen again. The point of this illustration is simply to show that no one knows what the market will do at any given point.
Can you imagine investing for retirement and seeing no growth in your account for 20 years?? We should not assume that by closing our eyes and “investing for the long term” that we will automatically get the results we are told to expect.
Some questions to ask yourself:
- At what stage in your life is it acceptable to experience a loss in your retirement account? 10 years? 5 years?
- Are you positive that your planned retirement age will coincide with the correct market timing?
For more information on how opportunity costs can affect your maximum potential in retirement years, please see the following short video.
(Video Source: Truth Concepts)
Our mission is to help your family and/or business realize its full financial potential. We help identify areas where money is getting away from you in the form of opportunity costs (taxes, fees, inaccessible cash) and bring that money back under your control.