You Should Be Rooting for Stock Prices to Fall

Beyond Buy-and-Hold # 40

It?s 1980, you?ve just turned 35, and you have only saved $10,000. You believe that you will need to accumulate $1,000,000 to finance a decent retirement. All of a sudden, it hits you — you had better buckle down or you are not going to make it.

You write your first budget and that makes it possible for you to put aside $10,000 each year for the next 30 years. And we see good returns during most of those years. The average long-term U.S. stock return is 6.5 percent real. For the 30-year time-period from January 1980 through the end of 2009, we saw an annualized return of 7.39 percent real, nearly a full point higher.

Did you make your goal?

Not quite.

A neat little gadget to calculate real returns on stocks

I have a new calculator at my site that does the math for us. It?s called the Returns-Sequence Reality Checker. It reports that you ended up with a portfolio balance of $896,080.

The real point of the calculator, though, is to show you how easily you could have made it. Small changes in the patterns by which stock returns play out can make all the difference. Few of today?s investors know this and it is in my view one of the most important realities of stock investing.

In 1980, we saw a return of 15.76 percent. In 2008, we saw a return of a negative 39.29 percent. What if the returns for those two years were switched? What effect do you think that would have had on your goal of accumulating $1 million in assets before you turned 65?

Such a change wouldn?t have any effect on the 30-year annualized return at all. That number is 7.39 percent in both scenarios.

But experience the big loss in the early days of the 30-year time-period rather than in the later days of the 30-year time-period and you meet your $1 million portfolio goal easily rather than coming up $100,000 short. $1,611,164. That?s the final portfolio balance in the scenario where you take your big loss -early and one of your many nice gain years late.

Timing is more important than return

Most of us invest in stocks hoping for strong returns. We are focused on the wrong thing.

The return we obtain matters, but not as much as we think. What often matters more is the pattern by which the return we obtain plays out.

You want losses — lots of them — in the early years of your investing life-cycle. Gains are fine when you are getting close to the point when you will be drawing down your portfolio to finance your living expenses. You don?t want gains in the early years. Gains in the early years hurt you.

That sounds strange. Gains cannot really be bad, can they?

Gains can be bad. Very, very, very bad. I believe we could bring about a revolution in investor psychology if we could help investors come to understand why this is so.

Say that you were planning on buying a particular car and you did research showing that the fair-market value for a car of that make and model and year is $20,000. Then you learned that a neighbor who you know takes good care of his cars was about to put a car of that made and model and year up for sale for $10,000. Would you curse your luck?

You would not. When we buy cars and cakes and cameras and comic books, we are all happy to pay low prices. We understand that the less that we pay for the cars and cakes and cameras and comic books, the more money we have to buy other products and services, products and services that go by names that do not begin with the letter ?c.?

We throw this commonsense approach to buying things out the window when it comes time to buy stocks.

When stock prices go up, your portfolio value goes up. That?s why you like price gains. You like to see a big number on the bottom line of the last page of your portfolio statement.

The thing you are missing is that, when stock prices go up, you have to pay more for the stocks you buy. Most of us buy stocks with each paycheck. When stock prices move upward, the price of the thing we are buying with each paycheck is going higher.

And the price increase will likely remain in effect for a long time. For those of us still a good number of years away from retirement, price gains represent a small plus and a big minus.

Price gains hurt us more than they help us. Conversely, price drops help us more than they hurt us.

Rob Bennett warns that there is such a thing as reverse compounding returns.Rob?s bio is here.

( Photo from Flickr by Helico )

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