09 Aug 2013 The Danger of Stock Market Compounding
You’ve no doubt heard the quote attributed to Albert Einstein: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” You understand that time can be your greatest ally or your greatest enemy depending on how much or how little you have to save. Finally, you’ve heard that younger people can be more aggressive than older ones when investing in stocks because they have more time to recover from setbacks incurred during significant market downturns. Today we’ll share some fascinating aspects of compounding that will surprise and perhaps frighten you.
The inspiration for today’s Brief comes from an article written by Michael Kitces entitled Long Term Savings, Relying On Returns, And Retirement Date Risk. The piece is a bit technical as Michael’s audience is professional financial advisors, but the warning it describes is universally important. The article demonstrates in a unique way what we continually harp on; that the sequence, or timing, of investment returns can be more important than the returns themselves. Sequence of returns can make or ruin a financial plan, yet few investors pay attention to this very real risk.
The compound interest Dr. Einstein refers to is fixed, or certain, for a determined period, like a CD or a bond on the receiving side; and a credit card or a loan on the paying side. But the concept of compounding is often used to refer to the power of the stock market as well. The idea of the ‘Magic Number’ for retirement touted by large brokerage firms rests on the idea that compounded investment returns over one’s investing lifetime are relatively consistent. But we all know that returns in the stock and bond market are anything but certain or consistent. Take a look at the returns of the S&P 500 index over the past 30 years.
Notice how much the swings vary. What if after five years of watching your $1 million portfolio rise to more than $2.2 million by the year 2000 you decided to stay fully invested in stocks. In the next three years your $2.2 million portfolio would have been reduced to $1.4 million.
Now, what if you retired in 2000 and decided to spend $100,000 a year from your portfolio. If you left your investments in the S&P 500 and didn’t reduce your spending during the three down years that followed (it’s unlikely you would hold your ground, but follow along) you would have had $1.2 million after the market declines, dangerously close to half what you started with after only three years.
The cycle repeated itself in 2008, but this time the losses were compressed to one year, not three. But the markets came back you say. Yes they did, but not before significant damage was done to both savers and spenders.
The potential damage of big market swings for spenders is obvious. What about the potential impact on savers? Using the same S&P 500 returns for the past 30 years we can demonstrate that savers experience equally dramatic swings as do spenders. Let’s look at 13 savers who invest $12,000 annually for 20 years, but each one starts a year later than the previous one.
The results are nothing short of amazing. The investor who started in 1981 and stayed with her $12,000 annual investing program, through the market’s twists and turns, ended up with $1.47 million, compared to the guy who started in 1989 ending up with only $376,105, even though he was just as diligent. She got a compound return of 15.3% and he got 4.1%. She realized $1.23 million in market appreciation beyond her $240,000 invested. He realized $136,105 on his $240,000.
Are you beginning to see the fallacy of the “Magic Number?” There is simply no way to know what kinds of returns you are going to get over the next 10, 20, 30, or 40 years because of the inconsistency of markets and the timing of your cash flows.
But wait, there’s more. An investment program relying on compounding returns whether it is on autopilot or actively managed is subject to another aspect of risk revealed before, but not explained. It is the issue that Kitces addresses in his article.
During the accumulation years we invest a relatively small amount (compared to our earnings and spending) each year toward our retirement goal. However, those small amounts invested in the early years are relatively large compared to our nascent portfolio values. As the years go by and our portfolios grow from contributions and the compounding of market returns, the contributions represent a declining impact on the annual increases of the portfolio. The market returns in the later years become the dominant factor in whether or when one reaches his or her retirement goal.
As Kitces puts it, “while there’s a benefit to starting early to enjoy the benefits of compounding growth, it actually makes the outcome remarkably reliant on returns in the final years; shortfalls towards the end simply cannot be made up with new contributions alone.”
These examples communicate in numbers and with logic, but the impact on the lifestyles of real people is much more important. The differences in outcomes cited above can have huge impact on the quality of a person’s golden years. Shortfalls can be revealed in amounts available to meet goals or in the timing of those goals, such as retirement.
Because of the examples above and for so many other reasons we use the Wealthcare process to understand each and every goal our clients value, the range within each goal, from acceptable to ideal, and the relative importance of each. The result is a comprehensive life plan that holds our clients hopes and dreams in the center of our process.
To address market inconsistency, we continually stress-test each client’s plan with the patented Wealthcare engine to measure its uncertainty, given current asset levels and goals. The results inform us as to whether their plans are within our comfort zone, over- or under funded.
Good market returns provide the opportunity to maximize a goal, meet one sooner, reduce market risk or savings, or some combination. An under-funded plan provides an early warning to make relatively small adjustments now to avoid big problems later (as the earlier examples demonstrate). Only with a tool like Wealthcare can you identify opportunities and threats that otherwise go unnoticed until too late.
Have a good weekend.