The path really matters – Part I
Posted on 18-02-2011 | 0 comments
Suppose you set out to accumulate savings over a long horizon – 30 years – and set aside €1000 each month. Now take a look at the two return paths shown in the chart below for a unit of investment over such a period. The upper (green) path generates a cumulative return of just over 6% per annum while the lower (red) path delivers a little less than 4%. Which would you prefer?
The obvious answer (to many of us at least) turns out to be a poor choice. For the profiles illustrated below, the particular paths shown would produce final accumulated sums of €758,000 for the green (6.1%) path and €1,016,000 for the red (3.7%) path. Of course, when you think about the timing of the cash flows, it’s no real surprise. For the red path, many of the poor returns fall in the early years when there is little contributed to the fund so they do little damage. By contrast, on the green profile the early strong returns are wasted since only a few contributions have been committed to the fund. Notice that for de-accumulation problems these effects would be exactly reversed so the poor early returns along the red path would be hugely damaging to a withdrawal strategy.
The lesson is pretty clear – for the purposes of understanding financial goals, the path really matters. It isn’t enough simply to focus on returns and their volatility. The sequence of returns will have quite different implications for different savers depending on their own pattern of contributions and withdrawals.
Finally, investment analysts often quote a ‘money-weighted’ or internal rate of return. This is the fixed return over the entire period that would produce the same cash flows. Of course, this depends on the returns and the timing, size and sign of cash flows. In this case the IRR is 4.5% for the upper path and 6.1% for the lower path.
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