AN AVERAGE TALE: “THE GOOD, THE BAD AND THE AVERAGE”

11 Aug AN AVERAGE TALE: “THE GOOD, THE BAD AND THE AVERAGE”

Understanding averages is an important part of understanding investing. Whenever you hear the word average you must train your mind to immediately ask the question, what happens when the average doesn’t come true? If you don’t you could be headed for trouble. This tale deals with what happens when a person only thinks in terms of averages and doesn’t understand what makes up an average.

Averages are factual but they have two underlying components. The first I call the good and the second I call the bad. Let’s look at an example to understand the good and the bad of an average. Let’s take as an example a professional basketball player that has a historical foul shooting average percentage of 80%. This means that on average every time that he shoots 10 shots he will make 8. Does this mean that every time he takes 10 shots he makes 8? If you answered yes you don’t understand averages and this tale is important to you.

What does an 80% average foul shooting percentage mean? Let’s break it down by the good and the bad. The good is what people call a hot streak and the bad is a cold streak. If you examine the actual way that an 80% foul shooter accomplishes his average you will witness a hot streak where everything seems to go in and for extended periods of time the shooter may make 85% or more of his shots. He might even make more than 15 in a row. However, when he’s cold you will see him shoot under 50% for a period of time. You might even see him miss 4 or 5 in a row. No one can predict when a hot streak will start or end. The only thing that seems certain is that the average will be 80% over a long period of time. It’s the same thing with investing in the long term. If you are investing in the stock market you know that average is about 10-12% per year. But you have no way of knowing if you are about to enter a hot streak or a cold streak. These hot and cold streaks are called bull and bear markets. Let’s see what happens when an investor plays the averages and doesn’t account for a bad streak.

I met Dr. Perez in 1985. He was in his late 50s and had accumulated a portfolio of slightly more than $2 million dollars. He had worked hard his entire life and had accounts scattered over multiple banks, brokerage firms and mutual fund companies. He wanted to retire and was interviewing a variety of advisors in order to find the one that would work with him and his wife over their retirement years. I was not a professional advisor at the time but worked with a few friends and relatives so he asked me to participate in the process.

Their goal was simple in his words. It was simple but it was wrong. He wanted to retire and have his money work for him instead of him having to work for his money. He felt that with the $2 million dollars that he had saved that he should be able to replicate his annual earnings of roughly $200,000 per year. He recognized that he was expecting a 10% return on his money but he believed that since the stock market had historically generated almost 12% that 10% wasn’t a stretch. He further delineated that at no time during his retirement would he expect less than $200,000 per year.

I immediately knew that this situation had the potential for disaster. Dr. Perez was trying to withdraw about 10% of his portfolio every year while I only recommend 5% per year. There was a very high probability that he would meet with failure and diminish the value of his portfolio well before his life expectancy. The Dr. as intelligent as he was had completely unrealistic expectations and didn’t understand what an average rate of return meant when someone is retired. Yes it might be possible to meet his expectations but only if everything worked out perfectly from the very beginning. Despite my strong suggestion that if he retired that he should reduce his annual expectation or delay his retirement he persisted. Despite my best explanation about what could happen if there was a bad period in the stock market, the equivalent of a cold streak for a foul shooter, he proceeded down a perilous path.

The Dr. was a family friend so I spent a considerable amount of time with him. The $200,000 per year was possible but highly unlikely. During this time I explained why my 5% annual withdrawal solution was appropriate. This 5% solution is an approach that factors in what I consider all of the pertinent variables associated with living off of your investments indefinitely. It factors in the mathematics of recovery, volatility, inflation and bad luck. Mostly, I spent time explaining the effects of initiating a strategy such as his at an inopportune time. I even showed him what happens if you start a program like the one he desired at the wrong time, which I call bad luck. He said he understood but that he wanted to go ahead with the program at the desired 10% or $200,000 per year. I think he just though I was incompetent and incapable of producing the market rates of return. Maybe he just was fooling himself. I don’t know for sure. What I do know is what happened over the next few years.

As a final measure I even suggested that if he was so sure that the market would earn him the historical 12% per year that he so dearly clung to that with his current level of assets he would only have to work an additional 6 years in order to accumulate sufficient capital to ensure that under my 5% solution, he could then safely retire with his desired $200,000 per year. He would hear none of that and we parted ways knowing that we wouldn’t be working together.

So what happened? Dr. Perez consolidated his accounts and invested his money with a large brokerage firm that is always Bullish on America and from my observation believes in selling past performance. They showed him how a diversified portfolio of the “right” equity mutual funds would satisfy his needs. These were top rated mutual funds that at the time had all generated 3-year returns in excess of 20% per year. In the Dr.’s mind this was a safe bet. See A Tale of Hindsight to understand why this wasn’t a safe bet. Things went smoothly until the fall of 1987 when his portfolio declined over 35% in 4 months. To make matters worse, it was just after this large decline that the Dr. took out his annual distribution of $200,000. By October of 1990 Dr. Perez’s portfolio had dwindled down to about $600,000 at which time the Dr. recognized that it was time to go back to work and move his portfolio to someone that knew what they were doing.

This tale ends on a happy note. The Dr. went back to work and kept at it until he reached a point were he had enough capital to retire successfully under the 5% solution that I originally outlined. Most people don’t learn from their investment mistakes and few retirees can ever recover. Dr. Perez is an exception to the rule.

I use this example to illustrate that you must prepare for the worst when planning your retirement. You must assume that though it’s unlikely that you will retire when the stock market hits a cold streak or a bear market that you must allow for the possibility. If you look back just over the last 20 years the individuals that retired in the mid 1980’s or late 1990’s to early 2000’s could have been potentially caught in a bad streak. This tale instructs you to know what average means and know how this will alter your lifestyle when you don’t get average results at the start of a program.

Carlos Sera
carlos@seracapital.com

Carlos Sera Founder of Sera Capital Management, LLC Co-Founder of Chicago Wealth Management, Inc. Registered Investment Advisor Speaker on Financial/Investment Planning Fluent in Spanish – First Generation Cuban/American Author of Financial Tales Blog Education Johns Hopkins University – BA – Natural Science – 1980 University of Rochester – MBA – Finance and Applied Economics – Honors – 1982 Find me on:  LinkedIn | Twitter

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