What rate of return should you assume you’re going to get on your portfolio when building your retirement plan? This is a critical input to any retirement planning endeavor. Few are lucky enough to not need any growth on their portfolio to fund their future plans. And I’d say even fewer do not desire any growth. Growth is critical to retirement success. This is because prices and spending needs tend to increase every year—some more than others. We call this nasty tendency inflation. And in order to keep up with inflation you’ll need growth.

So obviously a bear market that devours 50% of your portfolio would be a very bad thing if you were retired and depending on your portfolio for a certain level of income. But this is exactly what can happen and what has happened twice in the last 20 years, ruining the plans of many.

Too many people (and naïve financial advisors) rely on long term stock market averages to build financial plans. They quote the long term real return of the U.S. stock market, which is somewhere around 7%, and use that as an assumed rate of return for planning.

I believe this is a devastatingly big mistake. This long term assumed rate of return is calculated over hundreds of years of market returns. And I’m assuming that you don’t have hundreds of years to invest. No, what is more critical is the range of possible returns in a given year. For a person in retirement or near retirement, this is what matters. Over the last 100+ years, the stock market has shown extreme variation over a 1-year, even a 5- year period. If we look at all the 1-year periods from 1900 to 2014, the market has been up as much as 121.1% and down as much as 63.7% on a 1-year basis. How in the heck do you do planning around those numbers?

Stretching it out to 5 years does no better. The 5-year possibilities range from +34.1% average annual return over 5 years to -17.0% average annual return. Does adding bonds do anything? Consider a 60% stock and 40% treasury bonds portfolio. The 1-year range is anywhere from +63.7% to -40.7%, and the 5-year range is anywhere from +23.9% average annual return to -7.9%.

So, take your assumed 7% average annual return and flush it down the toilet. Averages over long periods of time are irrelevant. What matters is what can happen over the short term and how those possibilities will affect the success of your plan. The inevitable follow up question is: so what do you do to deal with the extreme downside that is possible in the markets? Our answer is that you adapt. Instead of holding a fixed percentage of stocks and bonds based on long term averages, volatility, standard deviation, blah, blah, blah—we believe a flexible approach that can adapt to market conditions is most prudent for retirees and indeed for all investors. Want to discuss further? Give us a call at 888-510-2362.