Just a reminder: These post titles are Financial Myths. In a concisely excellent article at producersweb.com, David Lewis gives us just one of many examples of the hazards of using financial entertainers (listed in the title of this post) as your financial planners. “What’s the problem?” you may ask.
Case in point is the difference between arithmetic (or “average”) and real returns. The first technique simply adds up a series of annual returns & divides by the number of years. So if you invest $100 and get 0% & 9% returns over the next two years, your average return is supposedly 4.5%. A 4.5% annual return would yield $109.20. But in reality you would end up with only $109, a 4.4% real annual rate of return. Is it coincidence that average returns are always equal to or higher than real returns?
Finally, for retirees one of the largest income planning risks is sequence of returns risk. If you’ve projected that the historically back-tested portfolio you’ve assembled will give you an adequate average rate of return for the rest of your life, as you draw it down, have you considered the effect of three years in a row of negative results? Using average returns fails to take into account the effect of withdrawals in declining years, declines from which it is often impossible to recover.