“Take a man and put one of his feet in a bucket of ice water and the other foot in a bucket of boiling water, and on average, he’s comfortable” – Mark Twain’s quote highlights the problem with averages.
This analogy is akin to what financial planners do when we use deterministic cashflow models, with assumptions based on averages. This model projects key variables in a financial plan – investment returns, inflation etc – in a smooth, linear format over time, when in reality nothing could be further from the truth.
The fact is, assumptions of long-term averages are unhelpful, especially in retirement planning. They can be easily thwarted by the powerful combination of volatility drag, sequencing risk and ‘pound-cost ravaging.’
Pound-cost ravaging describes how making withdrawals from retirement portfolios exacerbates the effect of volatility drag and sequencing risk. This drives home the point that, when in drawdown, the order in which returns occur is perhaps more important than the average return over a period of time.
This is why such assumptions based on averages are insufficiently robust. Especially in retirement planning.
The reality is, investment outcomes are unknown, so why pretend to clients that they are?
Abraham Okusanya is the principal at FinalytiQ