Many financial advisors – both the human kind and, more especially, the robo kind – will often rely on computerized portfolio optimization programs to recommend an asset allocation for retirement investors. I’ve mentioned in the past how the fatal flaw in these calculators is their inappropriate use of risk as a factor in these recommendations. This article isn’t about risk. It’s about something else I recently discovered (for the background on this, read “How a Fiduciary Can Assess a Retirement Investor’s GOT,” FiduciaryNews.com, August 5, 2014).
Many of these same optimizer programs use the average annual returns for various asset classes in their calculations. The most often cited average annual return for stocks (using return data dating from 1926) is 10% per year. How reasonable is it to use these historic returns as goals for retirement investors?
On the face of it, it sounds logical. After all, retirement investors are long-term investors and using the long-term average return appears to make sense. The truth, on the other hand, may not bear this out. If you look at the table in the article cited above, you’ll see, for time horizons of 25 years or less, there’s a one in three chance you won’t attain that 10% return target. How many retirement investors above 40 (i.e., those with time horizons of 25 years or less) have been sold on the idea of assuming a 10% return in stocks? The evidence suggests that assumption might not be prudent.
In fact, no time horizon using a 10% return assumption has even a nine-out-of-10 chance of being correct. As we approach shorter periods (and, ironically, longer periods), investors have no more than a 50-50 chance of earning 10% per year. If we consider this from a mathematical perspective, however, this regression is logical. Remember, the 10% annual return average is just that, an average. That means half the time you’ll earn more than 10% per year and half the time you’ll earn less than 10% per year.
That same table also reveals more than just the foibles of using a 10% annual return assumption. It shows how changing the time horizon changes the likely return. Let’s say you only want to use a return assumption that has more than an 80% chance of succeeding. (Hey, if four out or five dentists can’t be wrong, why not give investors a four out of five chance of meeting their goal?) This means only time horizons of 30 and 35 years can use that popular 10% assumption.
Time horizons of 25 years or 40 years and greater should use a 9% return assumption for stocks. Time horizons for 20 years should use a 7% return assumption. Time horizons for 15 years can get away with using a 6% return assumption. Time horizons for 10 years must use a 5% return assumption. Finally, time horizons from three to five years can only use a 1% return assumption. Remember, all these return assumptions are for stocks. Explaining the variance in reasonable return assumptions via this table appears far easier than explaining to the average investor the intricacies of a Monte Carlo Simulator. And, unlike the Monte Carlo simulator, these numbers contain no assumptions – they are based on actual returns.
So, is the historic average annual return for stocks – 10% per year – a reasonable retirement plan return target? More often than not, it isn’t. Of course, this assumes you’re only investing in the index. Your return prospects may be better (or worse) should you opt for managed (i.e., active) investments.
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