robert d. curtis
Assuming the average [return] is achieved each year ... should not be a best practice; ... it should be called malpractice." These are strong words from Dave Loeper, founder of Financeware and one of the evangelists of Monte Carlo. Since 2000, we've heard this message in one form or another many times from many experts. This standard practice of the profession went from being questioned to being criticized to being widely discredited. How could we have been so foolish as to think that we could predict a client's future results using average returns?
Obviously, no portfolio can be constructed to deliver average returns every year, and no client will ever receive them. Portfolio creation and investment decisions are always based on an expectation of volatility. Average returns reflect zero volatility. It takes very little analysis to demonstrate to anyone's satisfaction that the sequence of returns can make a great difference to the outcome of a plan. Hundreds of examples have been presented in various articles illustrating this point.
We certainly can't predict what the actual sequence of returns will be in the future, so if average returns aren't the correct assumption, how should projections be calculated? Fortunately, just as the use of average returns came under such great criticism, a replacement methodology was developed. And not only is the new method better than the old; it has been touted as "the answer" for financial planning. ...