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The “Luck Factor” in Investing
By JLP | August 29, 2007
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:
.GIF)
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:
ContributionLimits.GIF)
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:
2.GIF)
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.
Topics: 401(k), Index Funds, Investing, Retirement Planning |