Sequence of Returns Errors

Did you know that projections done with a fixed rate of return have roughly a 50% chance of being correct even if they’re based on a completely accurate average rate of return?  Half the time those projections will be too low but the other half will be too high, and sometimes way too high.

We’re talking about “sequence of returns” errors.  In the real world of investing, the return on your investments varies year by year and these variations affect the growth of your investments over the long haul.  “Volatility” is a term used to describe and quantify these variations.  The value of your investments at the end of the period will vary depending upon the cumulative effect of all the annual variations, even when the average of the annual returns over some period of years is constant.  If you have a sequence of above-average returns early in the period, your investments will tend to fare better over the long run.  On the other hand, if you have a sequence of below-average returns early in the period, your investments will tend to fare worse over the long run. 

Monte Carlo and historic simulations create a large number of unique return sequences and apply them repetitively to your investments, then analyze the long term effects over the entire set of return sequences or what I call “the range of outcomes”. The Pralana calculators distill and present the range of outcomes in terms of percentiles, where any given percentile represents the value below which a certain percentage of the results fall.  The Bronze calculator shows an envelope of results where the bottom of the envelope is the 10th percentile of results and the top of the envelope is the 90th percentile of results.  The Gold calculator breaks the results down into a series of envelopes with each representing 10% of the results to give you much better insight into the distribution of results over the whole spectrum.

Here’s an example from PRC Gold:

MC results from Gold

The solid red line near the center of the blue envelope is the projection based on a fixed rate of return over this 35-year period.  The various blue bands around the red line are the distribution of Monte Carlo simulation results broken down into 10% groups. 

The width of each band and of the entire envelope is a function of the expected volatility of your investments.  If your money is in CD’s, volatility will be low and the envelope will be narrow.  On the other hand, if a significant amount of your money is invested in stocks, volatility will be much greater and the envelope will be wide like the one shown here.

Projecting the future is impossible to do accurately but financial calculators employ one or more methods in attempting to do so.  Projections that provide a single outcome based strictly on fixed rate returns have value in helping you gauge whether you’re heading in the right generation direction and in making choices between multiple financial options; however, users should be aware of their inherent limitations.  Projections that provide a range of outcomes based on simulation of market volatility around user-specified averages or actual history (i.e., Monte Carlo or historical simulations) are imperfect too but have great value in giving you much better insights into how the future could unfold depending on the nature of your investments.  This helps quantify the potential upside as well as the downside risk to better enable you to make decisions and give you more peace of mind.  Even further, utilization of market volatility simulations in conjunction with consumption smoothing can be employed to establish your highest sustainable standard of living.  The Pralana Gold calculator can do this!

 

Pralana Consulting LLC, Plano, TX

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