Measuring Returns for
Different InvestmentConsumption Patterns
Question: An investment advisor tells his client to
invest $1,000 per month in VFIAX (Vanguard S&P fund) for five years. The person will then live off the proceeds
in this fund for 36 consecutive months.
Calculate the return on assets from this investment/consumption
plan for two different start dates – January 1, 2002 and January 1, 2003.
What is the NPV of investment returns from this investment
strategy/ consumption plan on the same start dates?
What should investors who are planning to save for five
years and spend for three years learn from this example?
Mutual funds and ETFs tend to advertise holding period
returns based on specific purchase dates and specific sale dates. These returns are based on the price of
securities on two dates only. What does
the example presented here tell you about the usefulness of twoperiod return
statistics reported by mutual funds?
Methodological Note: The shares purchased each month are $1,000/PVFIAX
where PVFIAX is the price of the ETF. I
sum over 60 months to get the total shares purchased, which I will denote
TSHARES. The formula for cash inflow for the 36 months are
(1/36)*TSHARE*PVFIAX.
The cash inflow/outflow column and the date column are
inputted into the XIRR function in Excel to give the IRR of the
inflows/outflows on these particular dates. The XNPV function gives net present
value of the cash flows.
An appendix to this post lists the data used in the XIRR and
XNPV calculations.
Analysis:
The value of VFIAX reached its pre financial crisis high in
10/2007 and reached its crisis trough in 02/2009. Hindsight is 20/20 but it appears as though
diversification prior to the downturn would have been beneficial.
What follows are return calculations for the two scenarios.
Results are in the table below.
Returns for Two
Investment/Consumption Scenarios


Invest Period

Consumption Period

IRR

NPV

2002/2006

2007/2009

12.04

$15,766

2003/2007

2008/2010

2.98*e9

$801

Observations:
·
The person who stopped saving in December 2006
did fairly well despite the financial crisis.
The IRR for this investor was 12.04 %.
The NPV of the investments was $15,766.
(NPV calculation assumes a5 percent cost of capital.)
·
The person who stopped investing in December
2007 realized a return only slightly higher than 0 percent. The NPV of this person’s investment was
around $800.
Discussion of Investment Strategy:
In my view, a 100 percent VFIAX strategy is unwise for an
investor with this type of investment and consumption period.
How to fix this problem is a more difficult question. It is important to note that the strategy of
putting 100 percent of funds in VFIA for an investor with a start date of
January 1 2009 or January 1, 2010 did quite well.
529 plans offer lifecycle funds that drift towards a more
conservative investment as the person nears the date where he must spend
money. Lifecycle funds would have done
reasonably well for both of the scenarios considered here. However, the lifecycle approach creates
miserable results when the market does poorly in the first few years of the
investment period and then rebounds.
My view on how to solve this problem is evolving. A 60/40 (stock/bond) portfolio would have
done well in these time periods but I don’t believe that it will work in the
next crash. Interest rates are now very
low and I expect in the next crisis bonds and stocks will crash together. Perhaps allocating some resources into an
inflationindexed bond fund would help balance returns during the next crisis.
The trend in investment is toward investment in passively
managed funds like the ones offered by Vanguard. This is at best a partial solution. Investors need help in allocating money
across several passively managed funds.
This includes advice on initial allocations and reallocation over time.
I believe there is a need for an actively managed fund that
invests exclusively in passively managed funds and reallocated assets across
funds as market conditions change.
Note on traditional
holding period statistics: The value
of VFIAX in January 2002 was 17.9. In
December of 2010 the value of VFIAX was 39.5.
The return for this 7.9 year holding period was at 10.5%.
Holding Period
Calculation


Jan03

17.9

Dec10

39.5

Holding Period in Years

7.92

ROR

10.5%

However a person who
started investing in January 2003 and started spending in January 2008 earned
squat!
The mutual funds can
legally and honestly report great eightyear or tenyear holding return but
their clients aren’t doing particularly well.
Such a surprise!
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