The Smart Take:
If your head is in the freezer and your feet in the oven, on average you may feel quite comfortable despite suffering from two extremes. San Diego type weather on the other hand will leave you consistently comfortable over time.
Averages are commonly used to discuss investment returns, but they are an oversimplification. You don’t receive average returns. Compound returns drive your dollar growth and the variability (volatility) in returns — or standard deviation — causes the compound return to always be less than the average return.
Listen to Kevin discuss this core building-block concept and how it relates to your investments, risk, diversification, and retirement planning success. You may hear the geek alert on this episode, but having an understanding of standard deviation can help you be a better, more disciplined investor and put the odds of retirement success more in your favor.
Need help making sure your investments and retirement plan are on track? Click to schedule a free 15-minute call with one of True Wealth’s CFP® Professionals.
3:54 – Re-Cap On Topics From Episode 65
6:28 – Bell Curve
10:49 – Health Analogy
15:00 – Proper Expectations
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Intro: Welcome to Retire Smarter with Kevin Kroskey. Find answers to your toughest questions and get educated about the financial world. It’s time to Retire Smarter.
Walter Storholt: It’s another episode of Retire Smarter. Thanks for being with us today, Walter Storholt, alongside Kevin Kroskey. He’s the President and Wealth Advisor at True Wealth Design. Serving you in Northeast Ohio, the Greater Pittsburgh area, and Southwest Florida. You can find Kevin online at truewealthdesign.com and schedule your 15-minute call with an experienced financial advisor on the team. Kevin, great to be with you once again, sir. How are you been?
Kevin Kroskey: Walter, I’m doing much better now.
Walter Storholt: You’ve been on the mend for a while.
Kevin Kroskey: Well, I was a little under the weather. The last time we recorded our podcast, I actually had to push it off because I was not doing well. I was like, maybe we’ll just do a replay of a prior one, and you were gracious and said, Oh, just push it a couple of days. And I still wasn’t feeling that much better.
Walter Storholt: Kevin wanted a day off, and I said no.
Kevin Kroskey: Basically, yes.
Walter Storholt: The show must go on, Kevin. It’s the rule of showbiz. Right.
Kevin Kroskey: I got through it. And then, when I was listening to it, I could just tell I was pretty flap and maybe not as coherent in explaining some things that I could have been in. And in fact, the way that I could most tell this Walter was you made a pretty funny joke about how you were a UNC alum, but you were also a Duke fan because your wife works there and do contribute a fair amount to the household income, which I thought was a great little tidbit that you put in. And by my response, I just didn’t even recognize how funny that was.
Walter Storholt: Kevin must not be up to speed on basketball rivalries here.
Kevin Kroskey: So what I wanted to do today was not start out with an excuse, but really, I think there are a few things that I mentioned in the last episode that I could do a better job explaining, but also are really important for people to understand. It is a little, as I like to say, egg-heady. So you might have to get out some geek alert music throughout today, but it’s really important for retirement income purposes when you’re using your portfolio to go ahead and create that income that’s going to last your lifetime. And there’s definitely some math underpinning it, but we will do our best. I will do my best to keep it higher level.
And some of this is going to be familiar to a certain degree, but I’m almost certain that some of it will be a little bit new and things that people necessarily have not connected the dots before. So we’ll break this up into the next two episodes. Try to keep it a little bit shorter. We’ll see if I can stick to that just because it is a little bit more egg-heady if you will. So try to make it more digestible.
Walter Storholt: Well, Kevin, I had the staff actually pull a little something together for us here. And so here we go. That is our new egghead alert sounder, in fact. So I had it prepped and ready for today’s episode.
Kevin Kroskey: That is awesome. Yes, let’s keep this. I have a feeling you might be sounding that with some regularity here forward.
Walter Storholt: I’ll try not to overdo it, but we’ll slide it in from time to time.
Kevin Kroskey: Oh, that’s great. That’s great. So I guess I’ll set the stage here, and we’ll see how this progresses, but the last episode was titled, should you sell an underperforming investment? And what I explained was a lot of times, it’s maybe not so much an investment problem, but more the style or the asset class is out of favor. The analogy that I always use to think about, you’re in the kitchen, the ingredients that you’re using in your recipe, or the investments that you’re selecting, and then the investment allocation, or how you’re combining the ingredients, is just that. And studies show that over time, the recipe actually matters more than the ingredients. And that’s something that a lot of people, I don’t think they, even if they know it, they probably don’t really appreciate it.
So certainly we want good ingredients, but ultimately we want a good recipe because that, in fact, does matter a little bit more over time. And one of the things that we talked about was that just because something’s out of favor, if it still makes sense to own it, every asset class is going to go through periods of time where it’s going to be out of favor relative to something else. It’s just investing in one of the things that you remarked quite positively to. I always quip and say, every time you look at your investment statement, there’s probably something that you should be unhappy with. Because if everything is moving in concert with one another, then that’s a pretty good indication that you’re not diversified.
And this idea of diversification can be defined mathematically, and it should be understood that way, at least by your advisor or by yourself, if you’re going it alone. But that’s really what I wanted to get into a little bit more. I talked about it to a certain degree. I mentioned something called terminal wealth dispersion, which I’m surprised you haven’t hit the alarm just yet, Walter.
Walter Storholt: I said I wasn’t going to overdo it. But just for posterity, sure we can.
Kevin Kroskey: So in the next episode, we’ll talk about that terminal wealth dispersion a little bit more, and it really does matter a great deal when it comes to retirement income. So this one, we’ll start off by talking about risk and standard deviation. And again, it relates to diversification to a certain degree, but we’re going to take it a step further in the next one, with that terminal wealth dispersion. And again, all this relates not only just to your investments but making sure that your money’s going to last and you have a good, effective retirement income strategy. So it certainly is important to understand. And we’ll start this off. Walter, do you remember the old bell-shaped curve from when you were going through school?
Walter Storholt: The bell-shaped curve? Yeah. My favorite of curves, actually.
Kevin Kroskey: I didn’t know you had a favorite curve.
Walter Storholt: One of the easier ones to understand in math class, I think.
Kevin Kroskey: Was one of your more favorite ones because you were on the right-hand side of that curve or were you on the-
Walter Storholt: That’s right. Just all I needed to do is be just a little right of center, and I knew I was in good shape. That’s right.
Kevin Kroskey: Okay. So let me just talk about this a little bit. I’ll use some numbers, but then we’ll come back and use some examples, and probably going to be a little bit better that way. But when you think about the market, just say the S&P 500, the standard deviation, or how consistent it is, if you will, if you look back over time, let’s just say it’s about 20%. There are periods of time where it’s a little bit more volatile than that. There are periods of time where it’s a little bit less than that. And Walter, I know you know this answer, and so don’t fail me now, but if you look back through long-term history on average, what’s the return to the market of the S&P 500?
Walter Storholt: Oh, 8% or so plus or minus one with a standard deviation of one.
Kevin Kroskey: I don’t know if there’s like an anti-egghead alert, but we might need to find one of those. So let’s just call the return 10. After 2019 happened, and candidly we’re early 2021 right now, I did look before recording this, but it’s probably closer to 11 now, if you go back a little bit more than the 100 years, or about the 100 years that it’s been around. But let’s just make the numbers a little bit more accessible for talking. Let’s just say it’s 10. It’s pretty close to about 10% annualized return per year and then a 20% standard deviation. All right. So if we think about our bell-shaped curve, that line in the middle is that 10% return. And what the standard deviation tells us, if you move out, like you indicated that plus, or minus one standard deviation from the average return, then what we do is we take the 10 and subtract 20 from it, which is?
Walter Storholt: Negative 10.
Kevin Kroskey: Negative 10. And then we take the 10, and we add 20 to it, which is?
Walter Storholt: 10.
Kevin Kroskey: I’m sorry, we take the 10-
Walter Storholt: Oh, that’s just not fair.
Kevin Kroskey: Anti-egghead alert. All right. So minus 10 to 30. So 10 plus 20 is 30. That was the answer that I was looking for. Thank you for playing Walter, but that’s the plus or minus one standard deviation for the S&P 500 if you look back round numbers over the last 100 years or so. So let’s pause for a moment, just digest that. So the one thing that comes out to me is, there are a lot more numbers if you were more of a range on the positive side or above zero. You have minus 10 to 30. It only goes down to minus 10. I like that, how that’s skewed, if you will, so you go all the way up to 30% there. So there are a lot more positive numbers than negative numbers.
And again, it’s simple and obvious, but I think it’s certainly important to point that out. And mathematically, you can say that, if you look back over all of those years that we’ve had the S&P 500 on average, the market goes up about two out of every three years or so. So again, that makes sense as well when you put it together. If we’re looking at that one standard deviation, what we can say is about two-thirds of the time, the return of the S&P 500 is going to be between that minus 10 and positive 30%. So again, one standard deviation about two-thirds of the time between minus 10 and positive 30. And so these are annualized returns, so it’s also something that’s important to understand.
If I go out one more standard deviation, so now we’re plus or minus two standard deviations, here we go, minus 30 to positive 50. And here, we can say with about 95% of the time or 95% confidence that yearly returns are going to be falling between those two numbers. So again, same thing, we have a lot more positive skew if you will there. One of the reasons why I think this is important is just to understand what to expect. When I was in my 20s, I’ll try making a little analogy here, but when I was in my 20s and 30s, it’s like I didn’t have any health issues. Yeah, sure, I’d catch a cold every now and then, but I didn’t have any issues that precluded me from being physically active from working out, jogging, biking, doing really whatever I wanted.
And now I’m in my mid-40s, and I’ve had several foot issues. I’ve got a partially torn rotator cuff, regular aches, and pains. And so, my definition of health is shifting a little bit. And I imagine a lot of people that are listening to this are going to probably tell me; it’s going to continue to do that as I age. But the long-term goal is as long as I’m relatively healthy and I have a long healthy life, that’s great. Ultimately I have to, I don’t want to say suffer through, but I have to accept some of those aches and pains. And when you think about the investment markets and retirement planning, ultimately, the basic goal of retirement planning is to make sure that your money lasts at least a little bit longer than you do.
We don’t know how long you’re going to live. We don’t know what the returns are going to be in any given year or anything like that, so we have this uncertainty. But statistics in this standard deviation tend to be a decent way to start at least thinking and dealing with uncertainty. Sure, you could go ahead and put your money down at the bank and just take whatever rate of interest the bank is paying you or not. And you’re going to have very little standard deviation, very little wiggle factor if you will. You’re going to have a very consistent return pattern. You’re going to have your corpus, your principal, plus some small rate of interest, which will move a little bit over time, but it’s not going to move that much or that quickly. But again, that’s probably not going to be the best way to make sure and put the probabilities in your favor that you’re not going to outlive your money.
So usually, that means that we have to start investing in stocks, which are inherently riskier, have a bigger legal factor or standard deviation like we just talked about. But again, we just need to understand that and know that that’s some of those aches and pains of investing in the market. In any given year, we could have a bad year, but over time, the market creates wealth, helps our money grow, outpace inflation, and will help us make sure that it lasts a little bit longer than we do for our retirement planning. The same thing you can think about for weather, so we’re recording this in February. There’s a huge snowstorm going through the Northeast right now, and it’s quite cold there. But you go in July, on the other hand, and it’s going to be really hot.
You average those two together. And it looks like Northeast Ohio has the weather of San Diego or something like that. But just putting your head in the freezer and your feet in the oven maybe means, on average, that you’re pretty good, but I don’t think anybody would really want to do that. San Diego, on the other hand, has very consistent weather pattern. It’s the boring, beautiful 70 degrees it seems every day there, at least usually when I visit, that’s what it’s been. So we see this consistency or lack thereof in other areas, whether it’s our health and things change over time, we get some aches and pains, and we get a new normal as we age, but we still have that long-term goal of being, having a long healthy life.
Or when it comes to investing, you can put your money into safer assets with a slower wiggle factor, less standard deviation, more consistency, but obviously, you’re giving up what may be a better potential to earn more over time in the stock market. Let me pause for a moment, Walter. I haven’t heard the geek alert alarm for a while, but how are we doing making the analogies here and making this a little bit more accessible?
Walter Storholt: I almost triggered it when you used the word, I think it was corpus.
Kevin Kroskey: Corpus. Yes. Principle.
Walter Storholt: Principle. Okay.
Kevin Kroskey: I think corpus is probably a Latin derivation.
Walter Storholt: There we go. That deserved it. The Latin derivation. Yes. That’ll usually trigger the egghead alert. No, I think I’m picking up what you’re putting down, understanding that concept and idea. I think the weather analogy is a perfect one. I’ve been to Hawaii three times, May, August, and November, the three different months that I was able to visit the state. And it was in pretty much the same part of Hawaii every time, and the weather was the exact same, every single time. Hawaii is either 88 degrees or plus or minus two or three degrees. But it’s pretty much always the same compared to the Northeast or the Southeast, where we have these wide-ranging temperatures. And I get the idea that to know how to pack properly for where you’re going; you have to take those things into account.
And so if we’re going to be in the market and investing, we just need to know that at least it sounds to me, Kevin, it’s still a pretty wide standard deviation. Minus 10 or plus 30, that’s a pretty big difference. If you use that standard deviation for the weather, we’re packing completely different clothes. Suppose we’re going on a trip that’s going to have that potential variance in our destination. So knowing that is okay, it just helps us prepare a little bit differently. And I also think back to last year with the drop in the market. It brings some comfort, I guess, when you experienced those anomalies, to know that, okay, this isn’t a normal year. This doesn’t fall in the standard deviation, at least at this exact moment. Although I guess at the end of the year, maybe it did fall within the standard deviation, which is interesting and ironic to think about.
Kevin Kroskey: Yes. I don’t want to get too far off a technical tangent here, but I would say that the daily returns of the market are not necessarily a bell-shaped distribution. That was normal distribution that we’ve been talking about. It’s something a little bit different. The tails are a little bit fatter if you will. But if you look at it on an annualized basis, it approximates the normal curve, or bell-shaped distribution approximated quite, quite nicely.
Walter Storholt: And that’s part of your point, right? You’re not trying to evaluate things on a day-to-day basis. It’s always bringing that thought process back to the longterm.
Kevin Kroskey: Not only bringing back to the longterm but making sure that we have proper expectations, so we can be a disciplined and prudent investor. If you’re not expecting that candidly, it’s normal that the market can sell off and go down minus 10, minus 20, maybe even minus 30%, then more likely than not, when that does happen. And inevitably, it will, you’re going to make a bad decision, probably a fear-based emotional decision and selling out at the same time when expected returns; future returns are likely going to be a lot higher. I don’t think I’ve ever, at least for the last decade, probably early in my career, I may have mentioned standard deviation in a client meeting, but I don’t do it anymore. I’ll say wiggle factor, certainly, I’ll talk about return expectations.
I think that’s important to understand, but mathematically, we worry about these things, but it’s what I would say for anybody listening to this needs a take away from it is to really understand that you need to have these expectations that this is in fact normal. That markets are going to sell off over time, and then when it does happen, when you do have a negative return, maybe a big negative return, what are you going to do about it? I can say from a retirement planning standpoint; we go through all of this with our clients. We have their goals in there. We have what it costs to go ahead and live their lifestyle. Anything that’s not being met from social security or pensions is going to be produced by their investment portfolio.
Their shorter-term dollars need to be in, generally speaking, in higher-quality assets that are more reliable and have less of a wiggle factor. But for most people, they’re going to need to go ahead and put some of their money at risk to have a growth over time with the expectation that’s going to grow over time and continue to build that wealth, continue to outpace inflation, and help them have their money last their lifetime. So it’s really about these expectations. Again, it’s not abnormal, and just because an investment… We’ve been talking about the S&P 500, but we talked about it in the last episode was really more about these asset classes maybe being in or out of favor. And the question was, Hey, when do you sell an underperforming investment?
And basically, the answer was, if it’s still a good part of your recipe, it’s probably normal that it’s just going through a period of time that you couldn’t foresee. You didn’t have the Back to the Future time machine and go into the future and get that book that Biff had, and just predict who was going to win the Kentucky Derby or whatever it was that he did to make all his money. We don’t have that crystal ball. We don’t have that time machine. So we deal with probability. We deal with uncertainty, and we try to do different things that will put the odds into your favor, to have things work, to have you make money, to have you manage risks, but you really need to have the proper expectations, care, and diligence to go ahead and stick with the plan over time. And that’s why I think definitely this concept is a little egg-heady, but this is why it’s also pretty important to understand how markets do, in fact, work overtime.
Walter Storholt: If only we could have our own copy of the Grays Sports Almanac of 1950 to 2000, like they did it Back to the Future that’d make the whole planning thing a lot easier to accomplish, but Hey, we don’t have that. So we have to settle for relying on you, Kevin, to guide us through these different conversations and make sure that we’re well-prepared financially into the future. I know that we triggered the egghead alert a couple of times on the show today, but ultimately I feel like we got some good clarity here. So I thank you for walking us through standard deviation. And even though you really tripped me up there with the minus 10 plus 10, now we’re going to go back to plus 20, I think you didn’t set me up for success there. So I’m calling foul on that first one. I may have to go back and review the footage, but I’m pretty sure you said minus 10 plus 20. I feel like I should get partial credit for that one due to the way the question was asked.
Kevin Kroskey: It’s quite possible. We will see. So I’ll wait for it to come out, and we’ll talk about it. We’ll talk about it in March. How about that?
Walter Storholt: There you go. That sounds like a good plan. And so on the next episode, we’re going to dive a little bit deeper into what terminal wealth dispersion is that sort of the direction that we’re going into the next egghead topic?
Kevin Kroskey: So now that we have the basics of standard deviation that we’re talking about. We can start talking about diversification and what that means and how most people probably understand it, I would say is lacking. And again, it matters a great deal because the whole purpose of this is tilting the odds in your favor. We talked about it in the last episode where some of the basketball analytics, we use the example of trying to push Coby to his left rather than to his right. And he had a lower probability of scoring or certain things that you may do in playing blackjack. And even though you’re not going to win every time, you still want to play those probabilities and put those odds in your favor. So that’s ultimately where we were and where we’re going. And we’ll dive into diversification a little bit more and talk about continuing to tilt those probabilities in your favor, so your retirement plan works, and your money last longer than you do.
Walter Storholt: And again, these conversations started with episode 65. So if you want to get some more of that baseline conversation, feel free to go back an episode and listen to that when it was about, should you continue to hold an underperforming investment? Good conversation; even though Kevin was a little under the weather, I think there were still a lot of good nuggets in there. So go check that one out, and then be sure to come back for the next episode, when we dive a little bit deeper into that topic of diversification and get a little bit more sophisticated conversation about that financial buzzword. Between now and then, if you have any questions for Kevin, don’t hesitate to reach out. You can call 855-TWD-PLAN, that’s 885-893-7526.
You can also go to truewealthdesign.com and click on the, Are We Right For You button and schedule a 15-minute call with an experienced financial advisor on the True Wealth team. That’s truewealthdesign.com, and we’ll put that contact info in the description of today’s show to make it easy on you. More is coming up on the next episode. I hope you’ll come back and join us. For Kevin Kroskey, I’m Walter Storholt. Talk to you next time on Retire Smarter.
Disclaimer: Information provided is for informational purposes only and does not constitute investment tax or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.