Thanks to the financial services industry, over the decades investors have been conditioned to focus on the returns their portfolios generate, more than on cash flow. The industry has emphasized returns, as they make a great sales tool for financial professionals. But that hardly helps investors (more on the problem with historical and average returns in my next column).
Of course, it is important to have positive returns, but simply focusing on this elevates what I call “sequence of returns risk.” This refers to the phenomena where portfolio returns in the early part of the investment cycle have a disproportionate impact on the long-term outcome of the portfolio – ergo, a 15% loss in year one has a compounding effect that is much greater than having a 15% lost in later years of the investment cycle.
The psychological impact of this is that it often causes investors to change their investment allocation to a more conservative mix, or worse yet sell near market lows, thereby compounding the impact of the early negative returns and making achieving their investment goals much more challenging. If, however, investors were to simply focus on cash flow, then they probably wouldn’t give in to any temptations to time the market or take corrective actions during a downtown, which is a natural part of a full market cycle.
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For instance, take two identical $1 million portfolios, which are set up to distribute $50,000 annually. Investor No. 1 has the unfortunate luck of investing at the peak of the market cycle and being subjected to two negative performance years at the outset. Investor No. 2 experiences positive returns for the first two years.
| Year | Portfolio 1 annual return | Ending balance after $50k distribution | Year | Portfolio 2 annual return | Ending balance after $50k distribution |
|---|---|---|---|---|---|
| 1 | -5% | $945,000 | 1 | 10% | $1,050,000 |
| 2 | -3% | $866,650 | 2 | 20% | $1,210,000 |
| 3 | 10% | $903,315 | 3 | -3% | $1,123,700 |
| 4 | 7% | $916,547 | 4 | -5% | $1,017,515 |
| 5 | -15% | $729,065 | 5 | 7% | $1,038,741 |
| 6 | 20% | $824,878 | 6 | -15% | $832,930 |
| 7 | 1% | $783,127 | 7 | 8% | $849,564 |
| 8 | -3% | $709,633 | 8 | -3% | $774,077 |
| 9 | 8% | $716,404 | 9 | 7% | $778,263 |
| 10 | 7% | $716,552 | 10 | 1% | $736,045 |
Average annual return for both portfolios = 2.7%
Experience has taught me that investors like Investor No. 1 will likely become nervous, and at the very least will doubt their strategy and be tempted to sell. Both portfolios have a 10-year average annual return of 2.7%, and both distribute the desired $50,000. The ending balance between the two portfolios is about $20,000 apart, well within a reasonable margin of error for long-term investment return expectations.
Astute investors know that portfolio returns are heavily influenced by market cycles, which are uncontrollable. By focusing on cash-flow, investors are better able to ignore short-term market gyrations and sequence of returns risk. In my next column, I’ll be discussing the importance and significant impact portfolio costs have on long-term performance.
This column is the third in a six-part series on investor education.
- Column 1 – Understanding your goals
- Column 2 – Why benchmarking to the S&P 500 is not a good strategy
- Column 3 – It’s about cash-flow, not returns
- Column 4 – How much are you paying for your portfolio?
- Column 5 – 5 critical questions to ask your financial advisor
- Column 6 – ‘Senior Inflation’ the not so silent retirement killer
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