Financial Calculators - More Harm Than Good? A Draining Tale

Posted by Carlos Sera on Jun 20, 2016 10:46:33 AM

financial calculators volatility drain more harm than goodI was recently at lunch with one of my long-time clients and her recent college graduate grandson.  We of course were talking about money and no money conversation is complete without a discussion about rates of return.  The grandson brought up the topic of financial calculators and that he had been playing around with them.  He wanted to know if they were something of value. 

For those that know me, you know where I stand on free things on the internet.  You get exactly what you pay for and in the case of free financial advice; it is often hazardous to your health.  I went on to explain that rates of return as shown on the types of financial calculators readily available on free web sites are an illusion.  I actually think they do more harm than good.  To understand how money grows if you are growing money or how to preserve your capital if you are preserving it, you must have advanced models and these models must be in the hands of someone that understands how money actually grows.       

They both looked at me quizzically and asked me to explain.  I explained that rudimentary financial calculators have two major flaws.  While they give you a warm and fuzzy feeling, they do more harm than good because they have no way to incorporate uncertainty and no way to incorporate the sequence of returns an investor experiences throughout their investment career. 

What do we mean by uncertainty?  Uncertainty is a substitute for the word volatility.  Volatility has a mathematical implication when it comes to calculated rate of return vs. actual rate of return. 

The financial calculator will always overstate your rate of return because of volatility

The more volatile the returns, the more your actual results will be less than what the calculator tells you.  What do we mean by sequence of returns?  The sequence of returns is just what it says.  For example, if you make 10% one year and 15% the next and 5% the next, the sequence is 10% then 15% then 5%.  Sequence of returns matters and unsophisticated financial calculators have no way of modeling how return sequence will enter your life.  As I said, be careful of free financial advice.

Since I was at lunch with two people that had very different investment objectives I went back to my office and ran some very simple models to illustrate the two glaring deficiencies of financial calculators.  For the grandson, I assumed he would invest $5,500 per year for 30 years at an average return of 10% per year.  For the grandmother I assumed she had $1,000,000 dollars and needed it to last for 30 years and she wanted to withdraw 5% per year for living expenses.  To keep things simple, I did not introduce inflation into the equation because it adds a wrinkle that defeats the purpose of isolating volatility and return sequence. 

What does the rudimentary financial calculator tell us the grandson will have in 30 years?  It tells us he will have $995,189.  This is what anyone that does this exercise will see.  However, it couldn’t be further from the truth.  Once again, why is it wrong?  It’s wrong because it does not factor volatility and return sequence into the equation.  This means a 10% return is not a 10% return.  It is less, and the more volatile the return, the lower the ending capital.  The grandson will end up with less than the $995,189.  That’s impossible you may say.  If this is what you think, you should play close attention to what happens next or ask us to send you a copy of our model.      

Let’s experiment by adding volatility and sequence of returns to the equation as a reflection of how the capital markets actually operate.  Let’s keep the average rate of return at 10% but make the returns have a 6% per year volatility.  So instead of 10% every year, make the first year 16% and the next year 4%, then 16% in the third year, then 4% in the fourth again, etc.  How much money does the grandson have in this case at the end of 30 years?  The answer is he has less.  He has $939,012.  If we increase the volatility to 12%, the sequence is 22% in the first year, then -2% in the second, then 22% in the third, then -2% in the fourth, etc.  In this case, the grandson only ends up with $830,818.  If we increase the volatility to 18%, the grandson only ends up with $689,454.  Can financial calculators be so wrong?  The answer is yes because they don’t factor volatility into the equation.  There is a name for this and it is volatility drainWhat volatility drain tells us is that how you make your return matters.    

Let’s stay with the grandson before we experiment with grandma’s money because there is one more lesson to learn about what can happen when you are accumulating money.  Let’s answer the question does the sequence of returns matter?  Let’s keep volatility at 6% and instead of having the sequence a 16% gain in the first year and a 4% gain in the second, let’s switch them around.  Let’s have the grandson make 4% in the first year and 16% in the second.  The results once again vary and the table below shows us by how much.

Invest $5,500/year for 30 years at a 10% average return while varying volatility and sequence of rate of return.

 

Volatility

Return

Sequence

Ending

Capital

Return

Sequence

Ending

Capital

0%

10%, 10%, 10%, 10%, etc

$995,189

10%, 10%, 10%, 10%, etc

$995,189

6%

16%, 4%, 16%, 4%, etc

$939,012

4%, 16%, 4%, 16%, etc

$989,173

12%

22%, -2%, 22%, -2%, etc

$830,818

-2%, 22%, -2%, 22%, etc

$922,469

18%

28%, -8%, 28%, -8%, etc

$689,454

-8%, 28%, -8%, 28%, etc

$807,781

 

The results are conclusive.  Volatility drain is real.  It lowers the rate of return that a rudimentary calculator provides and will disappoint you if you choose to ignore the facts.  Furthermore, sequence of return matters as well since it is better to begin poorly and finish strong while accumulating capital than the reverse.  To see just how strong this sequence effect is, read The Trampoline Effect..  Once you read it, you will understand that volatility can instead be your best friend if you let it work for you instead of against you.  

Let’s turn to Grandma.  She has a million dollars and wants to take out 5% per year and earn 5% per year on her investments.  Let’s see if volatility drain and return sequence matters to her future.  The table below says it all.  If she were to make a steady 5% per year and withdraw 5% per year, at the end of 30 years she would have her $1,000,000 intact.  Unfortunately, investing does not work that way.  Investments exhibit volatility and they exhibit a unique set of sequences.  As the table below clearly shows, how she makes her 5% per year matters greatly and is the reason why we design our wealth preservation portfolios with this in mind. 

Start with $1,000,000, make 5%/year, withdraw $50,000/year while varying volatility and sequence of rate of return.

 

Volatility

Return

Sequence

Ending

Capital

Return

Sequence

Ending

Capital

0%

5%, 5%, 5%, 5%, etc

$1,000,000

5%, 5%, 5%, 5%, etc

$1,000,000

6%

11%, -1%, 11%, -1%, etc

$981,102

-1%, 11%, -1%, 11%, etc

$792,122

12%

17%, -7%, 17%, -7%, etc

$757,020

-7%, 17%, -7%, 17%, etc

$409,906

18%

23%, -13%, 23%, -13%, etc

$411,528

-13%, 23%, -13%, 23%, etc

Broke

 

The table shows us that not all 5% returns are created equal.  As shown, grandma is broke if she has a volatile portfolio and starts at the wrong time.  The fact is that the composition of your portfolio matters and the sequence of returns matter.  Don’t let any financial calculator tell you otherwise. 

As an aside, one of my favorite beliefs is that “Logic is an organized way to go wrong—with confidence.”  Most financial advisors will buy some off the shelf software that’s a little more sophisticated than what you can get free and use it to develop a “plan” for you.  They even run what appears to the uninformed as sophisticated statistical trials called Monte Carlo analysis to give you the illusion that they know what they are doing with your money.  Most haven’t a clue what they are doing when they engage in this practice.  Not only does their software not factor volatility drain into the equation, nor return sequence, it also leaves out the last critical component that is beyond the scope of this post.  No software that I have seen models the persistency of returns into a financial plan.  Persistency of returns is very real and though it is a subcategory of sequence of returns, it is critical to your success.

For an example of just how hazardous to your health a volatile portfolio can be, ask yourself this question.  When I retire, would I rather own the best performing mutual fund in the country or a significantly worse performing mutual fund?  Most people would choose the top performing fund.  In some cases, they would be right but in others, they would be broke.  You can read A Tricky Tale to understand what can happen and take steps to prevent it from happening to you.      

So what’s the answer?  The answer for this example, is to make your 5% return in the least volatile way possible.  Ideally, an investment that makes 5% per year guaranteed.  Unfortunately, that isn’t something readily available in today’s environment.  With interest rates near zero and in many cases negative, achieving a successful outcome requires calculated risk-taking.  There is no other alternative.  If you want to see our calculated risk-taking and current holdings in our wealth preservation portfolio, we have it available on a daily basis at Covestor.  It is our attempt to reduce volatility while still providing the returns that grandma needs to make her money last.

Is there anything else we can learn from this grandma and grandson exercise?  The answer is surprisingly simple.  The benefit of sequence of returns flips between generations.  When you are young and accumulating capital, you want your better returns skewed towards the end of your wealth accumulation period.  A slow start doesn’t hurt you as long as you have a strong finish as The Trampoline Effect demonstrates.  However, the exact opposite is true for Grandma.  A slow start devastates her portfolio and reduces the likelihood of a successful retirement.  Volatility and sequence of return matters greatly.  The next time you use a free financial calculator, remember that you get what you pay for.  If you want a realistic calculation, you can contact us here.    

Carlos Sera is a Registered Investment Advisor Representative of Sera Capital in Annapolis, Md.

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Topics: Volatility (finance), Volatile Tales, volatility drain, financial calculator

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