It was one of those head-down dog days of summer, in blistering Houston, Texas. I couldn’t even raise my eyes leaving the building, under the blinding sun.
The Most Dangerous Four Words of Investing
Reluctantly, I folded back into my car where the dash read 110 degrees. I can’t guarantee the accuracy, but I was in the shade and I had never seen a reading that high before. On my way home, wondering if a car can actually melt….WHAM…a ball of ice hit my windshield. I was smacked with hail from skies that, just minutes before, were cloudless.
A violent storm immediately surrounded me, as I tried to get to my favorite restaurant takeout. I waited out the hail, for about two minutes, before running inside. Even though I had only five long steps to hurdle, I was covered in the biggest and wettest drops of rain I have ever felt and completely soaked in three seconds. My order now in hand I headed home, drenched and shivering just a bit. My exit is only two minutes away. I turn left, and head under the freeway into a different world. There was not a drop on the ground. In exactly 15 minutes, I was scorched with heat, hit with ice, soaked with rain, and then walked into a mild and dry evening.
The next day, after joking about the storm, I asked a friend, “Wouldn’t you like to move to a place where the average temperature is 68 degrees, where even at its hottest in July the average only hits 82, and in the winter it never goes below 50?” I will never forget his “absolutely” answer and about how much he loves southern California for that, twisting himself deeper into my math trap. Then, I explained that place I just described is called Houston, Texas – and a horribly deceiving concept called average numbers.
Losing Hurts More than Winning Helps
To use another extreme example, that also happens in real life, here are three years in a row for a popular stock index fund.
Year 1: +85%
Year 2: (39%)
Year 3: (21%)
That fund can advertise its average rate of return was +8.33% per year.
(85-39-21) / 3 = 8.33
Now take a real $1 through that same three years of actual returns.
Year 1: $1.85
Year 2: $1.13
Year 3: $0.89
Making projections based on averages, is a guess, not a plan.
That 8.33% average rate of return is correct, and so is Houston’s average temperature of 68 degrees.
Dig Your Income Streams Before You’re Thirsty
That misleading math really gets dangerous when a financial advisor applies a “safe” withdrawal rate based on the average.
Almost every financial plan we’ve seen referred to us uses a long-term projected rate of return for stocks, somewhere between +7% and +10%. Once again, that is not wrong, just completely unhelpful at best, and nest egg wrecking at worst.
The next time you hear a projection in that range, politely pause and ask that person how many years their number has actually happened.
We want to make you look good, so shhh….here’s the answer, to tuck away and shock somebody with the truth. Or, get kicked out of the next dinner party you want to leave early (with a sore foot after my wife stomps on it).
In the last 120 years, the Stock Market has finished the year landing on any decimal in that wide range, of +7% all the way to +10%, a grand total of…..five years.
Average rates of return are the four most dangerous words of investing.
In our humble opinions (managing money through two different 50% market crashes), you do not want to count on appreciation to withdraw from. Instead, dig multiple income streams before you are thirsty.
Your Income Plan should be treated no different than any other business. The healthiest businesses generate free cash flow, every year, consistently. They do not buy and sell stuff to make ends meet. Buying and selling every year in hopes it can sustain a withdrawal of principle is a guess, not a plan.
This short video explains what we learned, and what Wall Street hopes you do not ask about: