Did you ever think about how luck factors into saving for retirement? I never did until last night after I put together a couple of spreadsheets in Excel.

Take a look at this chart:

The reddish line represents the monthly growth of an S&P 500 portfolio using the actual monthly returns of the S&P 500, which you can download in an Excel spreadsheet here. The blue line represents what would have happened had the portfolio grew geometrically (meaning, the investments grew at the same rate each month).

When putting this illustration together I made the following assumptions:

1. I used the maximum 401(k) contribution available in each of the years. I did a little research and found the maximum employee contributions allowed since 1987:

I then simply took those annual amounts and divided them by 12 to get the monthly contribution amount.

2. To get the monthly geometric average, I simply used the geometric average function in Excel (you can read more about how to calculate the geometric average here).

Anyway, notice how the actual performance of the portfolio significantly trailed the return for the portfolio that grew geometrically. This is due to the significant drop that occured when the internet bubble popped in 2000. Notice how the drop occured after 13 years of solid growth:

Now, notice what would have happened had everything happened in reverse and the drop that occured in 2000 – 2002 occured at the beginning of the 20-year period rather than the end:

To make this chart I simply switched the returns around and made them occur in reverse order. Notice now how the portfolio performed significantly better in this example. This is because the big drop occured at the beginning rather than the end of the 20-year period. That’s where the luck comes in. If you must have a bad market, you want it at the beginning of your career rather than the end. However, even if a significant drop does occur towards the end of your career, don’t fret since the chances are good that you could be in retirment 20 – 30 years, which makes you a long term investor even though you will no longer be making periodic contributions.

So what’s an investor to do?

Nothing. There’s really nothing you can do about it so there’s no sense in worrying about it. I just wanted to bring it up to show you just how volatility can either work for you or against you depending on where you are in the investing cycle. Those who just started investing in the year 2000 are in pretty good shape since that drop occured at the beginning of their cycle.

### 14 responses to The “Luck Factor” in Investing

1. the hiccups can make people nervous and trigger happy, but if you look at the overall picture, the index has a nice steep upward trend. a definite plus for thinking long term and, although nerve racking, not worrying about the market gyrations.

2. Um… Don’t you expect the people who invested in 2000 will have their bubble before they retire? A person’s working life is something 25 years minimum but could be 40 years (or more). How many people can invest all that time and not experience a significant market correction or two?

You should check out Nassim Nicholas Taleb’s books “The Black Swan” and “Fooled by Randomness”. The second book is more accessible for the average reader. They address the effect of these big corrections (not just in the market, but in everyday life) are due unpredictable randomness and how we fool ourselves into thinking they can’t happen to us. But then after they happen we fool ourselves into thinking they were entirely explainable and foreseeable.

3. I like the illustrations – they tell a story about what can happen to investments. I also agree that there is not much you can do if you are invested in index funds or other funds that are already widely diversified. The main thing is to make sure you are diversified over several market classes and have the patience to invest for the long term and not to sell when there is a hiccup in the market. I started investing right around 2000, so I was buying as the market was declining. But, I am investing very long term and I expect things will be fine by the time I retire.

4. hi jlp. pls don’t get too angered by me posting this here. didn’t see a spot anywhere else. can you raise the question in this kind of format about health insurance. my wife and i (ages mid 50’s) will be on our own in 3 months. i know of 5 potentials out there – blue shield etc… curious what posters and readers think is the best. thanks love the site

5. I love the charts.

Here is another thought on luck. The day you invest can make a big difference. I just made my 2 Roth contributions for 2007. This totals \$8k invested in 1 day. As luck would have it, the forien funds I invested in wend down 3.8% on Monday and up 3.8% on Tuesday. I was lucky enough to have getten the money in at the low price Monday night. Now, I am 27 years old. If I leave the money there till I’m 57, it will have 30 years of growth.

Now a little math. Say the fund returns 10% per year (since they are more volitile funds), beginning today. \$8k invested today, would become rought \$140k. But, having invested it 1 day earlier, the total will come out around \$145k. Essentially, I have (by pure luck) gained \$5k at retirement.

Another point –
I’ve thought about this on several occasions. There have been wide ranging 30 year returns over the past 100 years. Some 30 year periods have returns 3 times that of others. So, there could very reasonably be a person in 1 generation that saves 10% of a modest salary and they have a kid that saves 30% and they end up with comparably the same ammount of money at retirement. I try not to let this get me down, but the truth is – we may have less than 50% control over our financial situation at retirement.

We have finantial tools that illustrate this at work. There is a tool our 401k plan uses that will project your retirment income. It gives confidence ranges as to what your nest egg will be at retirement. For me it has the following
10% chance of at least \$10mm
50% chance of at least \$4.5mm
90% chance of at least \$2mm

So, without varying my savings, I could end up needing to work till I’m in my mid 60s or be able to retire at 50, purely effected my market returns.

6. if a significant drop does occur towards the end of your career, donâ€™t fret since the chances are good that you could be in retirment 20 – 30 years

Eh, careful there. Since you are withdrawing, a significant drop early in retirement makes a BIG difference in the length of time your nest egg will last. Run some spreadsheets.

7. Try plotting the ROI on a dollar invested in any particular month and held until Dec 2006. Overall you’ll see that it’s better to invest than to wait most of the time except for the odd short periods, and the long period between ’98 and ’03. A dollar invested in mid 2000 would be worth \$1.50 today if you kept it under your bed for 3 yrs before investing.

There are only a few special months at the peak of the tech bubble where you would be worse off after 5 yrs if you did invest versus not investing, and even those are eliminated for 6 yrs.

8. I highly recommend 2 books on the subject, both by Nassim Nicholas Taleb: Fooled By Randomness and The Black Swan. The central point of both books is that history, and hence the market, is driven by random events. Furthermore, randomness is not easily modelled. The second book gives some suggestions for how to reduce the pain of negative random events and increase your exposure to positive ones.

1. - August 30, 2007

[…] The “Luck Factor” In Investing No matter whether you believe in market timing or not, this post will convince you that you’re right. (@ all financial matters) […]

2. - September 1, 2007

[…] JLP looks at the luck factor in investing and includes lots of pretty graphs. End result: “Nothing. Thereâ€™s really nothing you can do about it so thereâ€™s no sense in worrying about it.” […]

3. - September 2, 2007

[…] All Financial Matters charts the luck factor in investing. […]

4. - September 2, 2007

[…] The â€œLuck Factorâ€ in Investing by JLP @ All Financial Matters. […]

5. - September 2, 2007

[…] All Financial Matters: An interesting set of graphs shows how luck can make a difference to your investment portfolio. If there’s going to be a market crash, we hope it happens when we’re younger, so we can make up for any losses with time. […]

6. - November 25, 2007

[…] Check it out! While looking through the blogosphere we stumbled on an interesting post today.Here’s a quick excerptI just wanted to bring it up to show you just how volatility can either work for you or against you depending on where you are in the investing cycle. Those who just started investing in the year 2000 are in pretty good shape since that … […]