This post explores the inherent variability of stock market returns, and especially the impact that variability has on retirement planning. Understanding the risks your retirement plan is subject to is the first step in managing those risks.
Results of Investing $10,000 in the Stock Market: What Will $10,000 be Worth in 10 Years?
The graph above (click on image to expand), shows the historical results of investing $10,000 in the stock market for 10 years. The horizontal axis shows possible values of the portfolio at the end of the 10 years assuming dividends have been reinvested. The lines and bars reflect the frequency of various outcomes for 100 10-year periods beginning year-end 1899. (Note: to calculate ending portfolio values for an initial investment of $1,000, divide by 10. To calculate the results for n thousand dollars, multiply the results for $1,000 by n. For example, for a $100,000 investment, multiply the results for $1,000 by 100.) Following are some questions this chart can help you answer.
How Often Will My Ending Portfolio Be Between, For Example, $5,000 and $10,000(!!)?
The blue vertical bars show the number of years with ending portfolios in a given range. The scale for the bars is the vertical axis on the left labeled "frequency." For example, the first blue bar on the left shows that there has only been one year with an ending portfolio of between $5,000 and $10,000. (The labels show the upper boundary for each bar.) Thus, this happened only 1 in 100 times -- a probability of 1%.
How Often Will My Ending Portfolio Be, For Example, $30,000 or Less?The green line graph shows the cumulative percentage of years with ending portfolios at or below a given level; the percentage is read on the right vertical axis. As an example, we see that about 60% of the years ended with portfolios of $30,000 or less (note: this is also called the 60th percentile). Since the probability of ending with $30,000 or less has been about 60%, it follows that 40% of the years ended with portfolios of more than $30,000.
What Level Can I Be 80% Sure of Achieving?Note that being over the amount 80% of the time means you're at or below it 20% of the time. To make this estimate, start at 20% on the right vertical axis and see where the 20% line intersects the green line. As you can see, it is somewhere between $15,000 and $20,000.
Implications of Stock Market Variability on Retirement PlanningSuppose Pat is 55 years-old, receives a $100,000 windfall, and is planning to use it to retire at age 65. Historically, the average 10-year stock market return is about 10%/year. If Pat plans on a 10% return, he expects to have about $260,000 at retirement. However, that's not money Pat can be 100% sure of. This chart suggests over the past 100 years, equivalent investors would have accumulated retirement portfolios of anywhere between $90,000 and $580,000!
The good news is that in the past there were lots of 10-year periods when he would have ended with more than $260,000 -- sometimes much more. The bad news is that the probability of accumulating the planned $260,000 is less than 50%; i.e., chances are less than 50-50. In fact, based on past results, the single most likely outcome is a retirement portfolio of between $200,000 and $250,000, which could necessitate some lifestyle adjustments. Worse, there's even a chance he'll fall into the $50,000 to $100,000 range, ending with less than he started with; investors who invested $100,000 at the end of 1928 would have had only $87,700 10 years later.
This variability in results is a concern for investors in the "accumulation phase" of their retirement plan. However, when things don't go as planned, they have options (because they're still working and saving). For example, they might decide to delay their retirement a few years. Unfortunately, those in the "distribution phase" (already retired) have many fewer options. As a result, it is critical that they be conservative in their estimates. If Pat wanted to be 80% sure of reaching his plan, a plan of around $170,000 would be in order.
Notes: The above charts are based on DJIA (Dow Jones Industrial Average) data from my Stock Market Analysis Model/Spreadsheet. The distribution would be essentially the same if we used S&P 500 data. For this theoretical analysis, as usual we're ignoring the impact of taxes, commissions, management fees, etc. Years covered include year-end 1899 through 2008. Earnings & dividends prior to 1929 have been estimated based upon another market index. If you have trouble downloading the Excel spreadsheet, see this post.
Related PostsWhat Would $1 Invested in 19xx be Worth Now? This spreadsheet calculates the results for a specific 10-year period (or between any other 2 years).
How Much Will Your Bond/CD be Worth in N Years (Calculator) calculates results for any number of years at any interest rate.
Interactive Inflation Calculator calculates the impact of inflation for any inflation rate over any number of years
The Observations Inflation/Investment Spreadsheet the spreadsheet has additional capabilities beyond those of the calculators.
Other looks at variability in dollar returns
What will a $100,000 Investment be worth in 20 years?: similar to this post, but for 20 years.
Why Investing in the Stock Market for less than 5 Years is Risky: similar to this post, but for 1 and 5 years.
The Range of Market Returns in Dollars: 10-100 Years minimum and maximum values of portfolios after 10-100 years.
The Distribution of 10-Year Returns: an earlier take on 10-year variability. Contains a table showing historic annualized percentage returns for key percentiles.
What's causing the variability?
10-Year Rolling Returns vs P/E Ratio: Rolling returns graph with addition of the P/E ratio at the beginning of each 10-year period.
Starting P/E Ratio vs. 10-Year Returns: Shows the 10-year returns that resulted from each initial P/E ratio. The classic way to investigate causation.
Components of 10-Year Returns: Breaks out how much of each 10-year return came from a) dividends, b) earnings growth and c) change in valuation.
P/E Ratio Impact on Future Returns: compares returns of investors buying at low P/E multiples to those buying at high multiples, in percentages & dollars.
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Copyright © 2010. Last modified: 3/19/2013