So Easy to Be Fooled
How is it possible that the advisor and the client we discussed earlier could have been made to feel comfortable in choosing a payout of 8.5 percent or even 6 percent? Is it possible that we can be fooled, too? Sure, because our experiences of the recent past can substantially influence our judgments and create a bias that is too optimistic. Following this thought further, I wondered whether the average annual return for the ten-year period just prior to 1968 could have influenced an advisor’s projections and the retiree’s expectations. My research established that the answer was a resounding yes. From 1957 until 1967, the S&P 500 had an average annual return of 12.81 percent. Was that a surprise! In addition to the average return blunder, which is forward looking, I discovered the average return bias, which is backward looking. It goes to show that the advisor and investor could become victims of the times, the investor losing her retirement and the advisor losing an account and maybe his job.
Right from the first draw, the deck was stacked against the 1968 retiree. Not only had the average return assumption not produced results, the past decade became a poor predictor of actual year-to-year returns. Even if good data and a computer were used to generate a hypothetical illustration, that information simply was useless, if not dangerous. The power of the computer to show various scenarios is still somewhat meaningful, but a computer cannot predict the timing of returns. Advisors using such illustrations can mislead clients if they do not caution them about the probability that their assumption can be dramatically off.
