This is a guest article by Rob Bennett, a personal finance journalist and author of the blog A Rich Life. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s.
Most view the years from 2000 through 2009 as bad years for stocks. Returns were so low that many have come to refer to that 10-year stretch of time as the “Lost Decade” for stock investors.
This is a mistake. Those years were actually good years for most stock investors; it is the prior decade, the years from 1990 through 1999, that was more problematic.
To explain why I say this, I will need to report to you numbers generated by the Returns-Sequence Reality Checker, a calculator that I have co-developed with Sam Parler. Please don’t feel a need to learn how the calculator works to read this article. I will report the numbers it generated for me when I explored scenarios I will describe to you. If you like, you can return to the calculator at some later time and examine additional scenarios of your own.
The reason why I call the calculator “The Reality Checker” is that it throws doubt on one of our most fundamental beliefs about stock investing — that positive returns are good and that negative returns are bad. It’s not hard to understand why most of us think that. If your stock portfolio is valued at $100,000 at the beginning of the year and you see a 10 percent gain for the year, the portfolio is valued at $110,000 at the end of the year. If the gain is 20 percent, the ending value is $120,000. It’s obviously better to have $120,000 in your retirement account than it is to have $110,000 in your retirement account.
Except it’s not. Not really. Not when you look at what big, positive returns do to your portfolio balance in the long run.
The thing that fools us is that we think of ourselves as owners of stocks. In markets, the interests of the owners of the thing being offered for sale are opposed to the interests of the people considering buying the thing being offered for sale. Owners want high prices and buyers want low prices. To the extent that we really are owners of stocks, we are right to think of price gains as a good thing.
But we forget that we are not only owners of stocks. We are also buyers of stocks. Most of us are more buyers than we are owners. To the extent that we are buyers, we are rooting against our self interests to root for price gains.
Say that you have $10,000 invested in stocks today and that over the next 30 years stocks will be generating the same long-term return that they have generated since the U.S. market opened for business — 6.5 percent, after taking inflation into account. Are you better off seeing 10 years of 20 percent gains or seeing 10 years of 5 percent losses?
Both scenarios produce the same portfolio value at the end of 30 years: $66,144. Positive returns in the early years cause negative returns in the later years and negative returns in the early years cause positive returns in the later years. It all evens out over time.
But few of us invest a single lump sum in the market and then sit back and watch it grow over three decades. Most of us are buying stocks each year. That means that positive returns hurt us. Positive returns increase the amount that we need to pay to acquire stocks. The higher the price we pay for the shares we acquire, the lower our lifetime return and the smaller our end-point portfolio values.
You will be shocked to learn how big a difference this makes.
Say that you start with a portfolio of $10,000 and add $10,000 to it in each year of a 30-year time period in which stocks produce an annualized return of 6.5 percent real. In Scenario One, you see gains of 20 percent in each of the first 10 years. In Scenario Two, you see losses of 5 percent in each of the first 10 years. Do you care to take a guess as to how much difference that will make in the size of the two end-point portfolio values?
The Scenario One portfolio will be worth $549,859 at the end of 30 years. The Scenario Two portfolio will be worth $1,739,987. The portfolio with early losses grows to more than three times the size of the portfolio with early gains!
We’ve got it backwards! Losses (lower prices) are good. Gains (higher prices) are bad.
If you happened to start making annual contributions of $10,000 to the market in 1990 and the 30-year return ends up being the 6.5 percent average return that has applied for as far back as we have records, at the end of 30 years your portfolio value will be $746.162. However, if you happened to start making annual contributions of $10,000 to the market in 2000, at the end of 30 years your portfolio value will be $1,628,503.
We need more Lost Decades!
Published or updated April 7, 2011.