December of 2018 was a stark reminder that the stock market can be very volatile. When investors begin to flee stocks in droves, losses in the stock market can pile up very quickly. Combine that with all of the programmed trading that exists today and we now have a market that is more susceptible than ever to large, quick swings.
The Long Run Still Looks Good For Stocks
In the short run, extreme volatility can keep investors up at night. Losing 15% in one month, like we saw in December of 2018, can create major anxiety and leads to a lot of people selling into the downturn.
Short run volatility in stocks can be tough to stomach when the money invested will be needed within the next few years. The downturn can mean one cannot purchase the new car, put money into home improvements, etc. Of course, this is one reason why money that will be needed soon should not be 100% invested in stocks. It’s just too risky.
So what about investing in stocks for the long term? Should a 35 year old investor who plans on retiring in 30 years really worry about a 15% decline in his retirement portfolio? In general, the answer to that is a resounding no.
In the chart above we see the rolling average 30 year annualized returns starting in 1926. As you can see, money invested in the S&P 500 never has a negative annualized return over any 30 year period during this time frame. This is just another way of saying that stocks always go up over a long enough time horizon. Put another way, the longer your time horizon, the more likely it is that your stocks will have a positive return. Not only will they have a positive return over a long enough time horizon, but they will almost always beat bonds.
Longer Time Horizons Allow For More Risk
We hear this all the time: Start investing for retirement when you’re young! This is very sound advice because the power of compounding means that the growth in one’s investments can skyrocket over long time periods. What should also be added to this sound advice is: Take more investment risk while you’re young! At least this should be true for retirement investments that won’t be needed for 25 or more years.
Using the power of compounding combined with achieving higher returns (due to higher risk) over a long time frame is a recipe for a secure retirement. If one saves $10,000 a year for 30 years and only earns 3% per year, they will have about $475,000 at the end of that time frame. But if one takes a bit more risk and earns 7% per year, the amount at the end of 30 years would be nearly $1 million! That is one good example of the power of compounding at work.
How Time Horizon Impacts A Retirement Plan
I used a really detailed and easy to use financial planning application called WealthTrace to run a retirement plan so I could see just how it was affected by different scenarios. I entered a couple that is 30 years old and will retire when they’re 65. They save $20,000 per year combined into their 401(k) plans. They also plan on spending $60,000 a year once they retire.
I first looked at their probability of never running out of money (using retirement Monte Carlo analysis) when they are invested in 50% stocks and 50% treasury bonds. Their probability number was only 65%. But if I boosted their stocks to 90% pre-retirement and then back to 50% stock in retirement, their probability of never running out of money jumps up to 80%.
This is an interesting lesson in both taking more risk when you’re younger and then taking less risk when you’re older. After running a few scenarios I found that it is best for this couple to reallocate to a less risky portfolio right about when they retire. If they kept their money 90% in stocks the entire time, their probability of never running out of money was only 72%.
Moving them to a more conservative, diversified portfolio improves their chances of never running out of money. This makes intuitive sense because their time horizon is much shorter in terms of when they will need their retirement money. This also shows the benefits of diversification, especially as we get older and closer to needing our retirement money.
It really cannot be overstated how important it is to leverage the the time horizon when investing for retirement. Let the time horizon work in your favor. Start investing when you’re young and take more risk when you’re young with your retirement savings. Don’t let the short-term volatility keep you up at night if you won’t need the money for decades.