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Your Compounded Growth Rate Earned Will Only be Known At the End

I went to lunch with my colleague Bryan on Friday, and we had this discussion on investment outcome.

Bryan did some reflecting and realize how little assurance we can get about our investment returns: You will only know your compounded rate of return earned when you are near the end of your time horizon, looking backward.

I do see signs of a good wealth builder in Bryan. To be good, you need to prioritize your time, and spending enough time reflecting on the investing knowledge you read and distill them, then make use of them. Reflecting on what he has learned is a right step forward.

Bryan’s conclusion, however, is the unfortunate truth that each of us face.

You May Not Get the Return You Envisioned In the End

At the start of your time horizon, you need to plan for how much you need to get to where you want to at the time you wish.

In short: How much $X you need so that you can fund something in Y years.

To figure out $X, you will need to use some compounded growth rate. The compounded growth rate is usually based on historical returns.

You read some books like Random Walk Down Wall Street, Stocks for the Long Run, 4 Pillars of Investing (all are pretty good books to start).

The historical rate of return of a balanced portfolio lies between 7 to 9% a year. You then decide to be conservative and use 5% a year in your projection.

There is a problem here:

Past performance may rhyme across various rolling periods, but they do not always turn out the same way.

For example, over a 30 years period, if you get a 4% a year return versus the 5% a year return, it does not look very far off. For most people, they will still be satisfied since 4% is close to 5%.

$12,000 a year compounding at 5% vs 4% over 30 years.

However, in terms of magnitude, over 30 years, if you contribute $12,000 a year, at 4% compounded return, you will get $673,000. If it’s 5%, you will get $797,000.

The difference is $124,000 or 15.6% difference.

The difference is small when the years are short but with longer duration the difference is big. As you contribute more money, the difference in the absolute amount of wealth is also bigger.

Now, when you plan with 5% a year return, and you definitely need $797,000 at the end of 30 years, you have a $124,000 shortfall.

You have a shortfall and you need to do something about (like makeup for it from another source)

This is an uncomfortable aspect of investing. We live with markets that are part deterministic part random in my opinion.

If You DIY Invest, You have Another Layer of Uncertainty

If you are investing by yourself, by doing it yourself, you have one additional problem:

How do you know your active stock investing, forex, futures and options trading, property speculating skills will eventually give you the projected returns you read in books?

Wealth Machines - Competency - Active Investing
Investors often underestimate the effort required. It is hard to judge where you are. Sometimes good outcomes is due to luck.

The investing world is brutal in that even if you are a CFA, you are an analyst, you study finance in school, you are brilliant, you are a lawyer or doctor, you have a lot of wealth, you are a businessman, you may not eventually get to where the books tell you.

If I remember correctly, Professor Merton said that to truly assess whether a manager has an investing edge, and no luck, we require to assess a period of at least 20 years.

This means that we won’t know if we can gain real skill over our investing period or we are just lucky until we are near the midpoint or the end of the time horizon.

The opportunity cost if you don’t earn that rate of return over the time frame is big. We don’t have so many 20 year periods.  

A lot of wealth builders wake up one day 5 years later and realize their portfolio earned a compounded return of 0.40% a year when the general market earned 5% a year.

In the next 5 years, their portfolio would have to earn 20% a year to make up for the early 5-year poor performance. (but you have to take a lot more risks, and how many managers of funds out there use that kind of projected returns?)

How about Picking Good Funds?

The alternative of not doing it yourself is to invest in a reputed active manager upon the suggestion of your friends, investment adviser, financial planner.

Out of all the funds, a small number of them were able to outperform their benchmark. A large number of the funds may not last 20-30 years (we call this survivorship bias). Only a small handful of funds that were top in the last 5 years remain top in the next 5.

Even if they outperform the benchmark, you have no idea if you lived through a great period or a poor period. We also do not have much choices.

In short:

  1. We live through one period. This period can be good, it can be not good, it can be mediocre. There is nothing much we can do about it. And this impacts our rate of return.
  2. We will only know if we are skillful in our active investing or whether we picked a great fund at the end of the period. By then there are a lot of opportunity cost lost. And you need to make up for it.

So how should we handle this?

Some Possible Ways to Think About.

I do not have the perfect solutions but here are a few areas to think about:

  1. The mindset that you should have is the world going forward is unknown. We can use a conservative reasonable return in our planning. If the returns eventually fall short, your eventual plan is going to be less affected. If things turned out very well, you will reach your goals earlier
  2. Be prepared that your wealth value in the future is going to be very different from what your adviser, investment manager, or what you projected. Do not go around accusing people that “you promised this rate of return that time!” Not many people could unless there is a contractual guarantee and the firm does not default on it.
  3. Do the legwork upfront. Find out the investment strategies that have given a lot of people positive return expectations AND it is implementable.
  4. Do the investing work. Give yourself a period to see if it works out. Perhaps 3 to 5 years. Then make sure you put effort into it. After that, if it does not work out, either tweak one last time or fall back to the fallback plan
  5. #4 may not work out. At the same time, you got to have a de facto wealth-building standard. For some it is properties for some it is a portfolio of funds. For some reason, I realize when your net worth gets to a certain level, they put a lot of their net wealth in funds. Some of these funds are sound some of them are not sound. You can get people to help you to invest, but you best be at least sophisticated to be able to separate the sound ones from the unsound ones.

In all the advice, there is a sense of uncertainty whether you are going to get X% in Y years. And that is how it should be.

A lot of the times it is doing the right things, focus on the process and try to get better. Hopefully along the way even if you fall short, that short would still be immensely useful.

Lastly, if we think from the financial planning perspective, there are definite things that gives a high return on investments and within your control:

  1. Be flexible on your income expectations
  2. Put away money consistently into your portfolio
  3. Choose to delay when you need the money
  4. Optimize your expenses
  5. Curate your philosophy to spending & retirement

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Lyndon

Sunday 17th of November 2019

So far only the CPF Compounded Growth Rate is known at the start. :D

But indeed it is true for most investment instruments which do not have a "fixed returns or interest rate" subscribed at the start. Even when I do my wealth planning / building, I am pretty conservative and tend to underestimate what I may have at the end. See examples below:

For example for CPF, I use the standard 2.5% to 4% for all accounts. The extra interest and additional extra interest are left out in computation.

For insurance with cash value (e.g. endowment), I take my total maturity value as the computation of guaranteed + 50% of projected non-guaranteed at the 3.25% calculations.

For equities, I take a modest year on year annualised growth of 4% (same as CPF SA) which is not impossible to achieve and more.

What do you think of the "modesty way of thinking" that I have?

Kyith

Saturday 23rd of November 2019

Hi Lyndon, i think you have some conservative measures. The endowment one, it will depend on your perspective of how concrete are the payout. i would use the projection at 3.25% though. For equities, it depends on your experience. for some that have consistently achieve greater than 10% irr for a few years, using 5-6% is ok.

For some things that are traditionally non volatile, if we use too conservative of a metrics, we might be underestimating it too much. there is a balance somewhere.

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