Which Would You Prefer?

[haha]

Plan A: you invested a sum in equities, and over the next four years your annual total returns were 20%, 5%, 15% and -20%.

Plan B: You buy a 4 year CD at 4% with annual compounding.

Which plan leaves you with more money at end of year 4?

Ha

 

[Sam]

And the question is?

I can't wait the hear the correct answer.

 

[Cb]

I'd need to know what P/E10 was at the end of year 3.

Cb

 

[gindie]

The first case leaves you with 1.16 times your original investment.

The second case leaves you with 1.17 times your original investment.

Interesting. I bet most people would choose the first one w/o doing the math

 

[Cut-Throat]

Plan A: you invested a sum in equities, and over the next four years your annual total returns were 20%, 5%, 15% and -20%.

Plan B: You buy a 4 year CD at 4% with annual compounding.

Which plan leaves you with more money at end of year 4?

Ha

Mikey,

Knowing you I knew the answer was going to be CD's, because you dislike stocks currently. But, I worked the math and yes the CD's win by a buck or 2.

 

[Peaceful_Warrior]

If I knew the stock market would do that and I'd cash out exactly in 4 years, I'd take the CD and triple my profits.

However, being only 29 I'm in for the long-haul I'd jam as much into equities.... that's why there's 0% bonds in my 401k.

 

[haha]

Mikey,

Knowing you I knew the answer was going to be CD's, because you dislike stocks currently. But, I worked the math and yes the CD's win by a buck or 2.

C-T, good analysis, of me and the numbers.

Actually though, I was messing around with the concept of geometric mean (GEOMEAN in Excel). Although I vaguely understood it I recently got more interested because Dimson refers to it often.

It is kind of counterintuitive- those stock returns seem pretty good, but even a middling bad year hurts.

Ha

 

[JohnEyles]

Damn, I KNEW I shoulda put everything in those Penfed 6.25% CDs !

 

[Cut-Throat]

C-T, good analysis, of me and the numbers.

Actually though, I was messing around with the concept of geometric mean (GEOMEAN in Excel). Although I vaguely understood it I recently got more interested because Dimson refers to it often.

It is kind of counterintuitive- those stock returns seem pretty good, but even a middling bad year hurts.

Ha

That's why I think re-balancing plays an important role.

 

[d]

That's why I think re-balancing plays an important role.

it might indeed be worth noting that with these returns, if one split 50-50 and rebalanced at the end of each year, the return would exceed either of the two individual (buy and hold) alternatives.

 

[cute fuzzy bunny]

I'd have sold after year #3.

 

[audreyh1]

In case 1, you're up 16% after 4 years.
In case 2, you're up 17% after 4 years.

So, the CD would have done better, in this case.

But chances of the market rebounding 20% in year 5 is really good!

Audrey

 

[Sam]

I'd have sold after year #3.

Me too! And save myself a few minutes of math.

Now, what do I have to do to know ahead of time how well my investment will do? And I'm not talking about yearly performance. I wan't the daily numbers. I'm projecting 100 to 200% return per year.

 

[Rich_by_the_Bay]

It is kind of counterintuitive- those stock returns seem pretty good, but even a middling bad year hurts.

Interesting exercise. For me the biggest message is if you are accepting volatility in return for long term rewards, make sure you hold long term.

 

[cute fuzzy bunny]

I was kinda kidding, but honestly, if my investments popped up 40% in three years I'd get the heck outta there. Maybe buy some CD's...

 

[wabmester]

But chances of the market rebounding 20% in year 5 is really good!

But the market would need a 25% gain to rebound from a 20% loss....

 

[Shawn]

Depending on the definition of total return, Plan A is the better deal for me and most investors.

As other's have mentioned, the total return after 4 years is

Plan A: 15.92%
Plan B: 16.98%

However, a key consideration is the tax liability. My marginal tax rate (federal and state) is 34.7% for ordinary income and interest and 22.9% for capital gains. Assuming that both investments are in taxable accounts and that the return from the equity portfolio is from capital gains (no distributions), if I sell after 4 years my after tax return is

Plan A: 12.27%
Plan B: 10.86%

I'm sticking with the equities in Plan A.

The trick question has a trick answer.

 

[Cut-Throat]

Depending on the definition of total return, Plan A is the better deal for me and most investors.

As other's have mentioned, the total return after 4 years is

Plan A: 15.92%
Plan B: 16.98%

However, a key consideration is the tax liability. My marginal tax rate (federal and state) is 34.7% for ordinary income and interest and 22.9% for capital gains. Assuming that both investments are in taxable accounts and that the return from the equity portfolio is from capital gains (no distributions), if I sell after 4 years my after tax return is

Plan A: 12.27%
Plan B: 10.86%

I'm sticking with the equities in Plan A.

The trick question has a trick answer.

Yes, I thought of this also. But did not wish to complicate it, because tax rates vary by individual. But yes the stocks would probably do better after taxes.

 

[Sam]

But the market would need a 25% gain to rebound from a 20% loss....

Still better than the 4% CD.

 

[Helen]

I'd have sold after year #3.

Given my investment history, I'd have sold the CDs in year 3 and bought equities.

 

[wabmester]

Still better than the 4% CD.

Fine. If you're going to make the market go up 20% in year 5, then I bought a 7% 5-year CD.

 

[audreyh1]

Still better than the 4% CD.

Yep!

 

[Nords]

but even a middling bad year hurts.

If -20% is "middling bad" then I'd hate to see your definition of "painful".

Even in 2002 when one of our mutual funds was whomped -17% and two others were down 12%-14% (annualized, of course!), we still managed to limit the total damage to -2%.

So the example demonstrates that undiversified volatility can reduce overall returns...

 

[Toejam]

If -20% is "middling bad" then I'd hate to see your definition of "painful".

Even in 2002 when one of our mutual funds was whomped -17% and two others were down 12%-14% (annualized, of course!), we still managed to limit the total damage to -2%.

So the example demonstrates that undiversified volatility can reduce overall returns...

This is exactly what I was thinking, Nords. I prefer Plan A with the equities and plan to hold for the very long term as Rich_in_Tampa mentioned. I got clobbered really bad in 2000 because I had too much stuff in tech. After that experience, I made sure to diversify across sectors, size (small vs. large cap), and countries (international). I may be crying into my handkerchief 1, 3 or 5 years from now. But hopefully, it will pay off 15 or 20 years down the road. I'm willing to take the risk. In the meantime, I can happily live off my pension and rental income while the equity portion hopefully grows through individual stock appreciation (tax free until sold), through stock dividends, and through mutual fund/ETF dividends & cap. gains that are reinvested. I realize some may not have a pension or other sources of income to rely on after retirement, so it is understandable that the more steady and less volatile Plan B might be preferable.

 

[Cut-Throat]

But hopefully, it will pay off 15 or 20 years down the road. I'm willing to take the risk. In the meantime, I can happily live off my pension and rental income while the equity portion hopefully grows through individual stock appreciation (tax free until sold), through stock dividends, and through mutual fund/ETF dividends & cap. gains that are reinvested.

Your heirs will Love you!