Return of fans gives Garden-area biz a boost

Perhaps nothing in the financial world is more misused and misunderstood by the general public than the notion of rates of return.

Financial managers and media frequently tout these numbers as if they were the bottom-line consideration for every investment decision. Here’s an idea for you to chew on: For retirement income planning concerns, rates of return aren’t only not the most important consideration, they are both meaningless and deceptive.

Here’s an example: Say you have $10,000 worth of a market investment, and the market sinks by 20%. How much money do you have? That’s easy, you say, shaking your head dismissively: $8,000! Right! Well done. Now, the market goes back up 20%. How much do you have? Again, you shake your head, this time in bemusement. Why, $10,000, you say scornfully.

On the other hand, you might have caught the hook. The actual answer to the math question is $9,600 ($8,000 x

1.2 = $9,600). Many people are aware of this phenomenon, and the larger the numbers, the greater the disparity. For example, if the market goes down by 50% and then goes up by 50% the following year, you will end up with $7,500. It requires a 100% return to make up for a 50% loss.

However, there is a more fundamental truth: The answer to all these questions is zero. Nothing. Zip. Nada.

The truth is, you have no money in the market, ever. What you have in the market are shares, and the only way to convert those shares to money is to sell them. And there’s the rub: You have no idea what you will be able to sell them for until the time comes. Often you won’t even know the day you decide to sell.

For example, open-ended mutual funds clear at the end of each day. That means you might enter a sell order as the market opens and end up with an entirely different figure at the end of the day. This is one reason many portfolio managers prefer exchange traded funds, or ETFs, to mutual funds, as they clear just as the bid (the highest price the seller will offer) is met by a corresponding ask (and the lowest price the buyer will pay).

The difference is known as the “bid-ask spread,” or just the “spread,” and represents a cost to the seller. In a nutshell, the value of your shares is the amount someone else is willing to pay for your shares, which is always going to be the lowest price available.

And that just represents the swing that could happen in a single day. Imagine the swings that can exist over several days, or weeks, or years. In other words, you have no idea what your shares might be worth on the open market when you need to cash them in.

How can you plan based on that? The truth is you really can’t. The other truth is that this phenomenon invariably reduces the amount you can take out each month or year as income, because the timing of the price swings is much more important than the swings themselves. This is a phenomenon we call “sequence of returns.”

Here’s how that would work: Assume you have a retirement fund of, say, $500,000 from which you need to withdraw 7% per year over a 10-year period. Year one, you have a 28% gain, and year 10 you have a 38% loss, with returns ranging from plus-26 to minus-12 in between, all averaging 4.4% over the 10-year period. After a 28% gain and a $35,000 withdrawal in year one, you have

$605,000, and you’re off to the races. At the end of 10 years, you still have more than $300,000. Mission accomplished.

Now, leaving everything just as it was, we switch the beginning and ending numbers. You start with a 38% loss and end with a 28% return. After year one, you only have $275,000 instead of $605,000, and by the end of the 10 years, your balance has gone negative. All because the sequence changed, not the rate of return; it still averages 4.4% for the 10-year period. And the withdrawal amounts are exactly the same.

It’s not about rate of return, it’s about the sequence.

In a market that touts average rates of return over 7%. What’s wrong with this picture? Isn’t there a better answer? The answer to that question is an unqualified yes, and we can help you find it.