If, like me, you’re an occasional baker, you know how fickle fate can be. You can diligently whip up the ingredients in a recipe, stick the batter in the oven for the allotted time – and still wind up with a sunken mass of goo, completely unlike the airy showpiece in the cookbook photo.
Personally, I'm still scratching my head over the disaster that was my last Guinness ginger cake. (Maybe a case of too much Guinness imbibed beforehand for, um, medicinal purposes?) But I shouldn't be surprised by the unexpected results. Anyone who follows markets knows the same thing happens all the time to investors.
Two people can start with the same amount of cash and buy the same assets, but wind up with wildly different rewards simply because of when they happen to invest. Returns vary a lot from one decade to another. Even over much longer periods, the same volatility persists.
Consider a pair of investors I'll call Adam and Zeta. Back in the boom times of 1962, Adam pours all his money into the Standard & Poor's 500 index. For two decades, he faithfully reinvests his dividends. What does he earn, after inflation, for his 20 years of patience? Just a hair more than 0% a year. For him, stocks generate nothing but disappointment.
But then there's Zeta. In 1980, she ignores the sad experience of her friend Adam and pours all her savings into the market index, just like he did. However, she gets radically different results. Between 1980 and 2000, her money grows at the astounding average real rate of 15.6% a year. Shazam! Who wouldn't want to be in the stock market?
The problem for investors is that you don't know whether you will be Adam or Zeta until 20 years is up. Sometimes the market is madly generous; other times, it's brutally stingy. Back in 1962, Adam could not have predicted the stagflation of the 1970s. In 1980, Zeta had no way to foresee the '90s dot-com bubble.
Performance often varies widely
from one decade to the next
S&P Composite 10-year annualized real return
(%change)
20%
15
10
5
0
-5
1930
1950
1970
1990
2010
Performance often varies widely
from one decade to the next
S&P Composite 10-year annualized real return
(%change)
20%
15
10
5
0
-5
1930
1950
1970
1990
2010
Performance often varies widely from one decade to the next
S&P Composite 10-year annualized real return (%change)
20%
15
10
5
0
-5
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
How can you deal with such uncertainty? The classic advice is to be patient.
The longer you invest, advisers say, the more your returns will even out.
This is true – but within limits. Your planning can still be upset by a spate of bad results, especially if they happen just as you begin retirement. In that case, you run into a double whammy: a portfolio that’s suddenly worth a fraction of what it used to, coupled with the need to start drawing from your shrunken pool of capital.
Diversifying your investments helps, but even a steady, well-diversified portfolio can produce intensely volatile results.
According to Research Affiliates LLC in California, a classic balanced portfolio of 60% U.S. stocks and 40% U.S. bonds generated an after-inflation return of 11.4% a year during the 1990s. But that same portfolio mix lost 1.1% a year during the 1970s.
For generations, investors have tried to avoid this uncertainty by timing the market. Sadly, market timing is nearly always a mug's game. Any rule that pulls you out of frothy assets in time to avoid a crash usually gives away its advantages by being late to get back into the market when those investments start rebounding.
So, what can you do? My advice is to forget about trying to time the market and time yourself instead. If you're under 40, it pays to hold as much as three-quarters of your portfolio in stocks because you have decades to recover from a bad patch.
Between 40 and 55, a 60-40 blend of stocks and bonds is more appropriate. After 55, holding fewer stocks and more bonds is excellent insulation against disaster.
In any case, it pays to build flexibility into your plan. Being able to work a few years longer, or live on less, can go a long way toward offsetting even the worst luck. Bakers know their results can differ from those in the cookbook. So should investors.
Ian McGugan is an award-winning Globe and Mail writer. Reach him at imcgugan@globeandmail.com or on Twitter @IanMcGugan
Ian McGugan