Anyone paying even a little attention to the markets can feel like they’re on a roller coaster. Yesterday we were in for a bull run, tomorrow we’re in for a bear. The truth is, no one really knows. If the past is anything to go on, you can’t go wrong investing in low-cost index funds. They might go down over months or years, but the general trend has always been up.
Still, it’s not hard to get jittery. This comment stuck with me: “if you invested $1,000 in January 2000, you’d have $1,422 in January 2015; a 2.378% annualized return.” While that statement isn’t false, it doesn’t take into account automatically reinvesting dividends. If you take dividends into account, you’d have $1,881, or a 4.303% annualized return. Better, but I’d argue that’s not terribly spectacular either.
This is where market volatility comes in, and why it’s an opportunity. Imagine 2 worlds. The first is reality, where over the past 30 years (1985 to 2015) the S&P 500 had an annualized return of 11.34%. If you invested $1,000 in January 1985, come January 2015 you’d have $25,097. The second world is one where you get the actual average annualized return of the market, 11.34% each year.
So what do these worlds look like on a chart? The first chart reflects the reality of market volatility. It looks like a roller coaster.
The second one is probably the most boring chart ever created in Excel.
Here are the same charts now, but showing your account balance with an initial $1,000 invested. The first is the actual growth of $1,000. Notice that even though the first chart above goes negative for many years, you never actually lost money. Of course, that’s not to say you can’t ever lose money investing.
And here is if you got the annualized return. The second chart looks much nicer, even though both end up that the same place.
I think most everyone would prefer a guaranteed investment return, but since that’s not realistic, let’s look at the upsides to these charts. If they’re combined together, you actually can see there are many years you would actually get a better return than the average. 13 years the market performs under the average, and 17 years it performs above.
So what’s the upside to all of this? Imagine you had $1,000 to invest every year and could go back in time to 1985 and pick if you got the annualized return, or actual market return. Which would you choose? The correct answer is…
…you’d be better off with the average annual return, with an ending balance of $182,811 in the market, and $236,544 with the average annual return. What is interesting about this chart though is it all depends on your perspective. Someone investing from 1985 until 2001 would have done better with the money in the market. In fact, it’s not until the crash in 2008 that the average return does better, and even then, the gap is slowly closing.
But you can’t change history, and you can’t get a fixed 11.34% return anywhere I know of. So where is the opportunity? If we go back to the comment about the S&P 500 having an average return of 2.378% since 2000, we might have a rather pessimistic view of investing. But we’re all about slow and steady winning the retirement race, so we don’t look at a single year. Here’s what it looks like for someone who invested $1,000 every year at the average return since the year 2000, and for someone who actually invested $1,000 every year in the S&P 500 (without dividends reinvested, to match the dismal rate from the commenter).
The blue line shows the actual growth, with an ending balance of $25,104, versus $18,196 with the annualized return. That’s an average annual return of 3.5%. It’s not spectacular, but in this example, it’s about a 50% higher return than investing once and giving up. If you reinvested dividends, you’d have an average annual return of 4.7% (about 10% higher), with an ending balance of $29,818.
The irony is, when people say there was a poor return since some point in time, you actually would beat that low return if you consistently invested. When people give a sky-high average return, you probably do worse than it. The longer you invest, the closer you’ll get to the market average.
There are a few reasons why market volatility is an opportunity for investors. The first is there is no guaranteed investment that matches the average annual return of the market. If you think an investment in the S&P 500 made in 2000 did poorly, imagine it invested in a savings account or a 1-year Treasury with an annualized return 0.722%. While dollar cost averaging isn’t a sound investing strategy, in a way that’s exactly what you’re doing when you invest over your lifetime.
If the price of stocks only went up, each year you’d be able to buy less and less of them. Volatility gives you the ability to buy at a discount. Of course, it’s a double-edged sword. If you need to withdraw money during a downturn in the market, you’re doing so at a loss from your previous high. Still, there’s nothing you can do about it, so when every headline you see is trying to make the world panic, just keep chugging away at saving for retirement. The further you are from retirement, the happier you should be to see the market crash.
Volatility can also help you within an established portfolio. If you invested $10,000 in a technology fund (we’ll say Vanguard’s VGT) and $10,000 in an energy fund (say Vanguard’s VGELX) in 2004, you’d have around $23,731 of the tech fund and $20,985 in the energy fund in 2016. If you were a psychic you should have put it all in technology, but who knew? On the flip side, in 2009 you would have had $7,500 in the tech fund and $18,400 in the energy fund. Periods of volatility provide an opportunity to re-balance a portfolio at a potential discount.
If at the beginning of each year you sold either shares of the technology fund or energy fund to buy shares of the other fund to have a roughly equal balance in each account, you’d have a balance of $60,200 instead of $44,717 in 2016 (it might not be all roses though, depending how the accounts are taxed).
What’s the moral? Panicking and investing on emotions won’t get you anywhere. A sell everything mentality is short-sighted. If you invested money 30 years ago in the S&P 500, your annualized return would be 11.4%. If you were a psychic and pulled your money out in 2008 before the market crashed, and put it back in 2009, it would be 13.1%. If you waited until 2011 to put it back in, your annualized return would have been 11.7%. Is it worth it to even worry about it? Depending on the amount of time until you retire, a downturn in the market might even boost your ending retirement balance.