When you can visualize your financial future using one of the spreadsheets I’ve included recently, it’s fun to put in some really high rate of return and watch your future self get rich. Before the great recession a few years ago, there were a lot of people touting 18% returns, and a lot more people running the numbers and thinking they were going to be gazillionaires. We all know how that turned out. Yes, if you could guarantee 18% year-after-year, go for it. But, if fact, you may get less, a lot less, maybe more, or the whole thing could go bust. That’s volatility (on top of the risk of losing your original investment). If you want to gamble, go to Vegas. But when you’re talking about your financial future, you want some certainty.
Volatility, the uncertainty of returns, hits you even in some relatively safe investments. Take the example of the man retiring with $2,000,000 invested at 4%. A few posts ago I built a simple retirement spending spreadsheet that showed he could spend $80,000 a year and not run out for 27 years, when he’s 92.
But now if you throw in some modest volatility and do a Monte Carlo analysis of it with this spreadsheet, the certainty goes away. With a standard deviation (a common measure of volatility) of only 2.5%, there are no guarantees. This money will last those 27 years only with a probability somewhere between 75 and 80%. He’d need to cut his spending down to $70,000 a year to get near-certainty that it would last.
Try higher volatility (standard deviation) numbers to see how much harder it is to get near-certainty in your financial future.