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one thing i see get confused over and over on these forums is the difference between average returns and compounded returns.
there is a big difference between the two depending if you are accumulating the money or spending the money.
we can only spend compounded returns. compounded returns are what we get when the market is up 30% one year and down 20% the next year and up again the next year.
that balance is the actual amount of money we have to spend each year. very important if spending down in retirement or to live.
average returns are what we get when we simply average out all the results of the gains and loses and simply divide them by the number of years.
that is your actual gain when accumulating money but is meaningless when spending it down.
this factor is very important to figure when guessing what your savings will need to be in retirement based on average returns..
DR WADE PFAU computed that the historical average for the stock market net of inflation was 8.50%. however if you were spending down your compounded actual return was only 6.5% .
that is almost a 25% difference between the two numbers depending if you were growing money or spending down the money while getting those returns.
Last edited by mathjak107; 06-11-2014 at 05:33 PM..
DR WADE PFAU computed that the historical average for the stock market net of inflation was 8.50%. however if you were spending down your compounded actual return was only 6.5% .
Of course if you withdraw money from your portfolio and spend it your portfolio will be less than it was before. If you compute the gain, net of the withdrawal, it will be less than if you had not made a withdrawal. That is exactly what I would expect. What is so remarkable about that?
In any event, everyone should use a good RIP tool to properly compute forward-looking changes to your portfolio. It will take account of your desired withdrawals, inflation, and some will account for taxes also. It does not provide a compounded return, it provides a confidence level that your retirement goals can be met. Doing it this way one does not have to think about compounding vs. actual returns. The RIP takes care of that.
I am not sure what you are trying to say but it has nothing to do with what i posted. average return vs compounded return has nothing to do with your reference of the balance being less because you spent it. you can have the same average return in each scenerio. In fact you can have a bigger balance spending down when using a compounded return then the average return.
A true rip tool is using actual compounded returns year by year and doing the math yields different results that again most don't understand is different from using an average return.
I would argue you are wrong. The financial calulators like fidelity's rip or fire calc certainly use each years compounded return as it played out.
What they do not use is average returns.
DR MOSHE MILEVSKY wrote a very interesting paper a few years ago , RETIREMENT RUIN AND THE SEQUENCE OF RETURNS.
he took an example of a constant 7% return year after year based on a 7% average return over 30 years and drew 7% or 950 a month out starting at age 65 . the money was exhausted by age 86. this is typical of what uninformed folks do in an excell spread sheet or reverse amortization calculator when they have to enter a growth rate so they use an average.
next he took the same 7% average return and made it happen in different orders using compounded returns instead.
he made year 1 up 7% ,year 2 minus -13% and year 3 up 27% and repeated that pattern . the same 7% average return went broke at 83.
again , same 7% average return ,making the first year up 7% , next year up 27% and 3rd year minus -13%. you went broke at age 90. your money lasted 7 years longer than the example above with the same 7% average return.
next he did first year minus -13% , 2nd year up 7% and 3rd year up 27% . you were broke by 81.
that is also the same 7% average return
lastly he made 1st year up 27% ,2nd up 7% and 3rd year down 13% , same 7% average return and you lasted until 95.
that is almost 10 years longer than just figuring a constant 7% average return year after year . That is why i said your reference above made no sense to what was being discussed. In this last case your are spending down but had a higher balance then the average return.
the variation on the same 7% average return in how long your money will last is largely controlled by the order of those gains and losses.
in this case the same 7% average return most folks just throw in an excell spreadsheet and spend down didn't last until 86.5 like the spread sheet said. they went broke based on the order of that 7% average anywhere from 81 to 95.
the results can be quite different when average returns are used where compounded returns should be used.
Last edited by mathjak107; 06-11-2014 at 07:00 PM..
A true rip tool is using actual compounded returns year by year and doing the math yields different results that again most don't understand is different from using an average return.
I would argue you are wrong. The financial calulators like fidelity's rip or fire calc certainly use each years compounded return as it played out.
I am not sure you understand the concept of a compound return. Compounding requires reinvestment of a realized return on an investment, such as an interest payment. Unless you are reinvesting dividends, there is no compounding of an equity. It just grows. We as investors happen to look at its yearly growth, but that is not compounding, it is a snapshot of its performance for one year (or five or ten). A good RIP (such as Fidelity) tool uses the published annual growth rates for equities. Those are not compound rates and those are not average rates. They are unrealized rates of return for a one year period.
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I am not sure what you are trying to say but it has nothing to do with what i posted. average return vs compounded return has nothing to do with your reference of the balance being less because you spent it.
You were the one who said your actual return changes when you account for spending: "DR WADE PFAU computed that the historical average for the stock market net of inflation was 8.50%. however if you were spending down your compounded actual return was only 6.5% "
I was agreeing - of course the actual return is lower. It has to be - you spent part of it!
I am not sure you understand the concept of a compound return. Compounding requires reinvestment of a realized return on an investment, such as an interest payment. Unless you are reinvesting dividends, there is no compounding of an equity. It just grows. We as investors happen to look at its yearly growth, but that is not compounding, it is a snapshot of its performance for one year (or five or ten). A good RIP (such as Fidelity) tool uses the published annual growth rates for equities. Those are not compound rates and those are not average rates. They are unrealized rates of return for a one year period.
You were the one who said your actual return changes when you account for spending: "DR WADE PFAU computed that the historical average for the stock market net of inflation was 8.50%. however if you were spending down your compounded actual return was only 6.5% "
I was agreeing - of course the actual return is lower. It has to be - you spent part of it!
while fidelity, firecalc and any other RIP use annual growth rates of each year , those growth rates are COMPOUNDED as the years are analyzed as a rolling 30 year time frame. NO AVERAGES ARE USED and thats the whole point of what i am trying to convey.
YOU CAN'T SPEND AVERAGE RETURNS.
compounded returns play an important role in retirement planning . average returns play little to no part in retirement planning but folks try to use them all the time.
using compounded returns in your financial planning via RIP calculators vs using average returns in your excell spread sheet will leave you with those gaps in your planning milevsky illustrated unless every single year you are getting the exact same annual return.
Last edited by mathjak107; 06-12-2014 at 02:55 AM..
Drawing 7% is problematic, seems to me 4% is more reasonable
On the avg return rate I agree and have had to explain it over and over again to people
7% was used in his example because he needed a number that would illustrate the total draining. 6.5% was actually the historical average safe withdrawal rate over 146 years of rolling 30 year time frames if you eliminated the 2 worst time frames. it only fell to 4% when you included the 2 failed time frames at 6.5% and hense the 4% supposed rule was born.
stepping it up to 7% would drain things for the illustration of the effect of sequencing on compounded returns .
mathjak107 do you complains on yourself for spending too much ?
do i? nope not all ,but i can tell you the retirement graveyard is full of failed retirements because folks do not understand this concept when doing their initial planning.
a good example of compounded return vs average return would be the following and it has nothing to do with spending down or reinvesting dividends at all.
if you had a stock and it went up 100% the first year and the next year it fell 50% you would be right back to where you started with zero gain.
your average return is 25% but your actual compounded return is zero. you certainly are not up 25% as the average return suggests.
that is why you have to be careful even if not spending down .
if you want to play around with the s&p 500 and different time frames and compare average returns on it vs compounded or see the results with or with out inflation you can play here.
Last edited by mathjak107; 06-12-2014 at 03:32 PM..
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