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The Returns Sequence That Happens to Pop Up Makes a Big Difference

Beyond Buy-and-Hold #90

For stocks purchased at today’s prices, the most likely annualized 10-year return is 2.21. The highest return that could apply (assuming that U.S. stocks perform at least somewhat as they always have in the past) is 8.21 percent real. The lowest is a negative 3.79. That’s a lot of territory indeed! The factor that determines the point along that broad spectrum of possibilities on which your actual return will fall is the returns sequence that happens to pop up.

We cannot know in advance what returns sequence will pop up. That’s why the range of possibilities is so broad. First, I am going to show you why this is not a super big deal. Then I am going to show you why, while it is not a super big deal, it is a significant matter that you need to be aware of and take into consideration.

The Strategy Tester

I went to the Strategy Tester and entered the following assumptions: (1) an initial portfolio value of $10,000; (2) a $10,000 contribution to the portfolio in each of 30 years; (3) a 3.0 percent real return on money not invested in stocks; and (4) a starting P/E10 value of 20 in a secular bear market.

I looked at two types of investment strategies, both using this same group of assumptions: (a) a Buy-and-Hold rebalancing strategy of 70 percent stocks at all times; and (b) a Valuation-Informed Indexing (VII) strategy in which the investor goes with 100 percent stocks at P/E10 values of up to 8, 90 percent stocks at P/E10 values from 8 up to 16, 60 percent stocks at P/E10 values from 16 up to 21, and 30 percent stocks at P/E10 values higher than 21.

The calculator shows that at the end of 30 years, the most likely return for the Buy-and-Hold portfolio is $776,000. The most likely return for the VII portfolio is 1,039,000.

The highest possible return for the Buy-and-Hold portfolio is $1,096,000. The best possible return for the VII portfolio is $1,612,000.

The lowest possible return for the Buy-and-Hold portfolio is $581,000. The lowest possible return for the VII portfolio is $667,000.

The Returns Sequence Affect

The calculator is reporting that the investor following the Valuation-Informed Indexing strategy may have a portfolio value at the end of 30 years of $1,612,000. Or he might only have a portfolio value at the end of 30 years of $667,000. That’s a difference of nearly one-million dollars! I am not going to be the one to tell you that the returns sequence that happens to pop up does not matter much when an unlucky sequence can bring you down to the tune of one-million smackers.

The same is so for the Buy-and-Hold investor. He may see a portfolio value at the end of 30 years of $1,096,000 or he may see a portfolio value at the end of 30 years of only $581,000. That’s a difference of nearly half of one-million dollars. We’re not talking small change here. Return sequences matter.

But wait.

I don’t make much of a fuss about return sequences in my writings. Why don’t I, given these amazing dollar values? Shouldn’t I be paying more attention to this aspect of the story?

Some investment factors can’t be controlled—and this is one of them

The returns sequence factor is a significant factor. You really do need to understand the concept to be an effective investor. It would be wrong of me to entirely ignore this factor. But the full truth here is that, while the dollar figures are huge, this is far from being the most important factor bearing on your long-term stock return.

There are two reasons.

One, you cannot control the returns sequence that happens to pop up. Returns sequences are determined by the emotional ups and downs of millions of other investors. You cannot control or predict those emotional ups and downs. If you could, I would place much more focus on this factor.

Given the realities that apply, I don’t think you should direct much mental energy to the task of thinking about this factor. A one-million dollar factor that you cannot control is a factor that makes a big difference on paper but that does not lend itself to much in the way of strategic thinking in the flesh-and-blood world.

Valuations: The Real Story

Two, you can control how the valuations factor plays out for you. What makes valuations so critical is that valuations also have a big dollar impact over the long-term but the valuations factor is one over which you can exert a good bit of positive influence.

Please remember that the only difference between the two scenarios examined was the way in which the investor responded to valuation swings. The Buy-and-Holder went with the same allocation at all times. The Valuation-Informed Indexer took price into consideration when setting his stock allocation. All other factors were the same for both investors.

In the worst-case scenario, the Valuation-Informed Indexer had a 30-year portfolio balance of nearly $100,000 more than the Buy-and-Holder.

In the best possible scenario, the Valuation-Informed Indexer had a 30-year portfolio balance of $500,000 more than the Buy-and-Holder.

In the most likely scenario, the Valuation-Informed Indexer had a 30-year portfolio balance of $250,000 more than the Buy-and-Holder.

The returns sequence that happens to pop up matters. Your willingness to adjust your stock allocation as needed in response to big price swings matters more.

Rob Bennett’s web site contains his article on saving for retirement and how not to impress your date. His bio is here. For background on the Big Fail of Buy-and-Hold and on the need to move to Valuation-Informed Indexing, please check out the “About” page at the “A Rich Life” blog.

( Photo from Flickr by Helico )

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