Investors should be careful about the phrase ‘average returns’

In Odd word, by way of Caesar’s Palace and Russian Roulette, we introduced the subject of ‘ergodicity’ for the first time, here on The Value Perspective. It is undoubtedly an off-putting name but the concept actually has the potential to offer some very helpful insights to investors – as author and investor Taylor Pearson explained to us on our podcast through the hypothetical example of retiring couple Nick and Nancy.

Nick and Nancy, who also show up in Pearson’s excellent article A Big Little Idea Called Ergodicity, are both 65 and set to retire on 1 January 1966. As it happens, they have been extremely diligent savers over the course of their lives and have accumulated a tidy $3m (£2.34m), which the pair calculate they can invest and live on – withdrawing $180,000 in year one and growing that 3% a year to account for inflation – until they are 95.

Integral to this calculation is Nick and Nancy’s almost clairvoyant forecasting ability, which means they know for a fact the US stockmarket will return an average of 8% annually over the 30 years to 1995. “Under this model,” says Pearson, “Nick and Nancy’s total wealth peaks around age 75 at about $3.5m and then they are slowly drawing that down until age 95.

Sequencing risk

“And you might think, with that average 8% annual return, the couple will easily have enough money – but that is not actually correct. After all, the annual return is not going to be 8% every year, is it? Some years will be 10%, some 6%, some may be negative 10% and some may be positive 30% and the order in which those returns come matter a lot. This is ‘sequencing risk’.”

Nick and Nancy may have been spot-on in their forecast that the US market would return an average of 8% annually between 1966 and 1995 but, year to year, those returns varied a lot and the market was not kind to the couple. “From 1966 to 1982, there were essentially no returns,” says Pearson. “The Dow Jones began the period at 1,000 and ended it at the same level.

“But then, from 1982 to 1995, the Dow went from 1,000 to 8,000, returning more than 15% per year. So even though Nick and Nancy were correct about that 8% in terms of the average rise, the implications for them are very different and the sequence of the returns matters a great deal. If the big returns come in early, they are in great shape; if they come in late, they will run out of money long before they planned to.

False confidence

“So talking about ‘the average return’ over 30 years can create some false confidence. Nick and Nancy’s model assumed ergodicity – that the time average and the ensemble average are the same – but for them as individuals, that is not the case. Their scenario was non-ergodic. They cannot obtain the returns of the market because they don’t have infinite pockets – they can’t just keep adding assets into their retirement portfolios.”

None of which is to argue against investors taking a longer-term view. As we have made clear time and again, here on The Value Perspective, if you are putting money into equities, you should be willing to leave it there for three to five years – at the very least. Still, taking the ‘average returns’ of a market at face value risks creating a false sense of security and investors should be prepared to think more deeply when planning ahead.

That being so, say Pearson could go back in time to 1965, what advice might he give Nick and Nancy to help them plan a less financially fraught retirement? “There are two obvious things,” he replies, “and the first is just to build a margin of safety into their hypothetical model. If they planned for their money running out at age 110, say, rather than age 95, then the sequencing in this non-ergodic scenario becomes less of a risk.

Plan for the worst

“The other thing would be to think about risk in terms of drawdown – how much could they lose and what would that look like? – and optimise their portfolio for that, rather than volatility or variance, which is how people typically talk about risk. They are 65-years-old and investing heavily in the stockmarket so the worst-case scenario is some sort of crisis or crash that sees equities decline significantly the year after they retire.

“That would put Nick and Nancy in a really tough situation – not only do they have to make up all those losses to get their plan back on track, they are also no longer earning. So, in their planning and portfolio construction, they need to be looking at what makes sense in terms of limiting their potential drawdown – it is just a better way to think about investing than this potentially misleading idea of ‘average returns’.”