My goal is to prove to you, the skeptical reader, why sometimes market volatility is a good thing for us. Like so many others in the financial blogosphere, I am addicted to spreadsheets.
Let me preface this by saying, this is not to say you should be 100% allocated into equities. But like I mentioned to Financial Samurai, I believe too many of us Gen Yers are way too risk adverse when it comes to investing our money for the long-term. The point is that you should have a predetermined investing strategy and desired asset allocation. Market movement and sentiment should not change this. Market volatility should not change this. It’s times like this that help new investors learn their spot on the risk continuum. But it’s also headlines like this that are the equivalent of financial porn. And they are out there almost every day, many times on major media sites. Ignore the noise and stay the course.
Now that I’m off my soapbox about creating a plan and coming up with an asset allocation, I wanted to look at a hypothetical portfolio with different growth rates throughout time. I spend quite a bit of time forecasting out net worth, retirement planning, other financial nerd stuff, etc. Until recently, I have always assumed a constant growth rate. But what happens if instead of assuming constant growth, we assume cyclical bear/bull markets that might be more realistic based on history. I was suprised by the results.
Here are my base assumptions:
- Freddy the Finance Nerd is 27 years old
- He earns $60k salary and expects to average a 3% raise throughout his career
- Even though he slightly wants to blow all his money on hookers and coke (see what I did there), he instead is committed to contributing 10% of his lifetime salary into a 401k plan. His employer will match at 5%.
- He holds his 10% contribution constant throughout all his working years (this is an important assumption!)
In this example, we will look at 5 different scenarios for the upcoming 33 year outlook. Each of the 4 scenarios with growth will average 7% return annually.
- No Growth: 0% return
- Constant Growth: 7% annual return
- Bear 5, Bull 5: -5% return for 5 years, 19% return for 5 years and so on – last 3 years assumed 7% return
- Super Bear 5, Bull 5: -11% return for 5 years, 25% return for 5 years and so on – last 3 years assumed 7% return
- Bear 7, Bull 7: -5% return for 7 years, 19% return for 7 years and so on – last 5 years assumed 7% return
The results can be found below.
Maybe you’re surprised, maybe you’re not. I was. But it makes sense. All 3 scenarios with bear/bull markets (cyclical) outpace the constant growth scenario. I also realize that time doesn’t stop when we turn 60 and we likely have 2-3 MORE decades in the market after that.
The no growth and constant growth are pretty straightforward. Over his working lifetime, Freddy & his employer have contributed about $450k to his 401K plan, which grows to about $1.5M with a consistent 7% annual growth rate.
But with the cyclical market scenarios, something remarkable happens. For 5-7 year stretches throughout his career, Freddy is able to effectively purchase more shares of whatever mutual fund or index fund because the market is going down, down, down. By staying the course, Freddy is effectively dollar cost averaging during the down times and gets the benefit of amazing returns during the up times. This translates into a 33-55% increase in Freddy’s 401K account (depending on which cyclical scenario we are looking at) after 33 years compared to the constant growth rate scenario.
This only works if Freddy is consistently contributing money into his 401K. If he tries to time the market and decreases his 401k contribution during perceived bad times and increase during perceived good times, he could end up just about anywhere on this graph.
I’m not saying that I guarantee an average 7% return, but if it happens I sure as hell want it to happen in peaks & valleys instead of at a constant rate over time.
Being in my 20’s I have to remember that market volatility will be present throughout my accumulation phase. A down market (*cough*2016*cough*) means cheaper shares and at the end of the day, that’s what we are accumulating – numbers of shares.
I can understand as someone gets into their 40’s, there might be some resistance to this idea of thinking hoping for MORE market volatility. I would still argue that if you are resistant to the level of risk associated with increased market volatility, you should be changing your asset allocation to lower risk investments. This is, of course, because higher 401K balances raise the stakes and the magnitude of risk.
In your 20’s and 30’s, my argument would be that market volatility is a good thing for our accumulation and our path towards financial independence because of the decades that we have on our side.
At the end of day, my sentiment has less than 0% impact on the movement of the market and . So in that case, go down ms. market and get me some cheaper shares these next couple years!
So what do you think readers? Is market volatility good or bad? Have I gone absolutely crazy? Shoot some holes in my theory.