Over the next few months, I will be blogging you three letters of the “Improving Financial Health” series about retirement planning. This is Part 1 which covers a very important misconception that many investors have that: Market Averages Matter. I believe your understanding of the concepts discussed may be vital to whether you are comfortable in retirement.
Any time is a good time to improve your financial health, and an excellent place to start is with what you think may be true, but isn’t. So for the next few months, we’ll examine a few misconceptions so you can understand and overcome these hurdles to financial health.
A comfortable and confident retirement is on most people’s list of reasons to invest. The financial services industry has done a pretty good job of educating investors about the growth phase. But little has been done in preparing investors—or even advisors—to adequately handle the retirement income phase. And the rules are different. As you think toward retirement, what should you do to prepare yourself for the income phase of investing—where your money pays you?
If you make a mistake early in the growth phase, it can be relatively easy to recover. Let’s say you don’t contribute the legal limit to your 401(k), IRAs, or other retirement plans, or you take some wild risks, or even cash out of the market at the wrong time—you may still have years to decades to make up for lost time. Early mistakes are easier to fix. A mistake in the income phase is different: It could jeopardize your lifestyle for the rest of your life, as well as your legacy. An income-phase mistake can have an impact on your income every month for the rest of your days.
These kinds of life-changing financial mistakes generally fall into two categories. The first I call the “hope strategy,” in which we simply hope that things will work out fine and make no effort to learn about what we can do to increase our chances of enjoying a comfortable retirement. The second kind of mistake is doing the opposite, which is, “drowning in information.” In this case, investors consume a vast amount of raw data and then act, or decide not to act, based on a misunderstanding of this information. The misconception we will examine in this letter is an example of this second kind of mistake.
Misconception: Market Averages Matter
One way to misunderstand raw information is to confuse abstractions with reality. Market averages are such an abstraction. Averages do not actually exist. Market results exist—and nothing compels actual market results to obey averages.
Let’s look at an example. According to Dimensional Fund Advisors, looking back from 1926 through the end of 2016, the S&P 500® stock index averaged a return of about 10 percent annually. But out of all those 90 years, how many times did it actually provide a calendar year return between 10 percent and 11 percent? Did you guess 20? 30? 10? Try one. Just One. Is that too narrow of a band? Then let’s find out how many times the market’s return was between 8 percent and 12 percent. Surely 30 or 40 of those 90 years, right? Actually, the market’s return was in the 8 to 12 percent range just six times. In fact, the market’s loss was greater than 20 percent more times than it returned a gain of 8 to 12 percent. But that’s only part of the story. The market’s gain has been 20 percent or greater 31 times out of those 90 years.
The stock market is like electricity. If used prudently with the right risk management tools, like insulation, regulators, and wall sockets, you can have light to read a book at night, enjoy air- conditioning in the summer, and listen to music on the radio. Using it without proper respect and understanding can give you quite a shock.
The stock market’s returns don’t go in a straight line—they never have. Expecting a return of 10 to 11 percent each year would have left you feeling a little off course in 80 of those 81 years. Making sure your retirement plan is up to task requires planning for the inevitable times investments will under-perform their historical averages.
I can help you with preparing for the times when your investments do under-perform their historical averages. I’m just a call away.