Luck Has a Lot to Do With It

I seem to be on a niceness streak lately. Yesterday brought another item written by somebody other than me which I nevertheless liked. Try as Investors Might, So Much Depends on NYSE-Mod-SmallChance, from The Wall Street Journal, tells us that a person’s lifetime of investment returns is dependent primarily on  accidents of birth rather than skill.

We spend a lot of time wrestling with investment selection angst. This mutual fund or that one, active or passive, 20% in bonds or 50% in bonds, and so on. Those are important and hard questions, but there is a forest-for-the-trees danger here.

The biggest driver of long-term investment returns is not an investor’s skill but the overall market returns over the period. In other words, whether you wind up living large or living modestly at 70 is largely luck.

Of course there are other factors. How much you save is an obvious one. And there are plenty of opportunities for acting foolishly in a way that will jeopardize your retirement. But for most people, what the market returns over a relatively short period, the 20 or 30 years before retirement, is the single biggest determinant of retirement wealth.

Consider somebody born in 1916 who turned 65 and retired in 1981. In the 20 years before his retirement the stock market averaged a return of only 6.57%, just 1.07% ahead of inflation over the same period. $100,000 invested in the market on his 45th birthday would have been worth $357,026 at 65.

Now consider someone born 17 years later, in 1933. Over the 20 years before his retirement in 1998 the market averaged 17.32% a year. (That happened to be its best 20 year period since 1890.) $100,000 invested on the last day of 1978 would have grown to $2,440,288.

The difference between $357K and $2.4M is tremendous in terms of retirement wealth and lifestyle. And yet all that separates these two people is the year in which they were born. And those years are not even that far apart. The 20 year investment periods actually overlap.

Individual investors often cheer themselves with the observations that a) the stock market has gone up by more than 10% on average for more than a century and b) although it is volatile, by holding on over decades a person can get closer to the long-run average return.

Those observations are not wrong, exactly, but their import is easily exaggerated. That the US stock market has gone up double digits on average over the past 120 years is a factually correct statement of history, but it does not necessarily follow that going up an average of 10% a year is part of the inherent nature of the market.

And investing over 20 years is less risky than investing over a shorter period, in a way, but it is not diversifying in the conventional sense. Putting all your money in a single stock for 20 years is not like putting a twentieth of your money in each of 20 stocks for one year.

In the 20 stock portfolio case your total return will be the average of the stock returns, that is, the sum of each return times 5%. If one goes down 50%, your portfolio is down only 2.5%. But the 20 annual returns from the single stock do not get averaged, they get multiplied. If one year is down 50%, your 20 year return is half what it would have been otherwise.

I still think the stock market is the single best asset class available for long-term investing and that spending the time to select the best form of that investment is important. But it is also important to realize that, like many things in life, in this respect our control over our destiny is limited.

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