Young Investors, Would You Pass The Wizard’s Test?
You’re feeling great. You’ve just invested your first $10,000 in a portfolio of index funds. What’s more, you’ve committed to saving a further $1000 a month. Just as you ponder your wealthy future, your little dog begins to bark by the door. If you don’t take him out, he’ll poop on the carpet… again.
You grab the dog’s leash, clip it onto Poopie and run outside. While walking down the street, your neighbor (known locally as Old Wizard) is tinkering in his garage. You wander over to see what’s going on. Old Wizard looks up and asks, “So, what are you proud of today?” The odd duck loves asking that. You explain that you just invested $10,000 into a portfolio of low-cost index funds and that you plan to add a further $1000 a month.
Old Wizard grins and asks, “Would you prefer to see the stock market average 6.5 percent per year over the next 20 years or 9.33 percent?”
He’s famous for asking quirky questions. “I would prefer that stocks average 9.33 percent over the next 20 years, not 6.5 percent,” you say, humoring the old coot.
He rubs his white beard, raises his eyebrows and asks, “Would you prefer that stocks have three horrible years in a row, starting this year or would you like to see stocks soar over the next three years?” He might as well have asked, “Would you prefer that Poopie not leave smelly gifts on your carpet?”
“Obviously, I would prefer to see big gains right away,” you say.
“That’s normal,” says the wizard, “But if you want to do well in the stock market, you can’t think like a normal person.” He rushes to the back of his garage and pulls out a huge, flat piece of cardboard and a black marker. Then he writes this:
20-Year Investment Durations
|Scenario 1||Scenario 2|
|Stocks average 9.33% for 20 years||Stocks average 6.5% for 20 years|
|Stocks soar for the first 3 years||Stocks drop for the first 3 years|
“You’re young,” he says, “So you should celebrate when stocks don’t perform well.”
It must be true what they say: The old wizard is a fool. But you’ve been taught to respect your elders (even the eccentric ones) so you stick around to hear what the old codger says next.
“Take your dog around the block,” he says. “I need to find a larger piece of cardboard. Come back in 20 minutes.”
You try not to laugh as you leave the wizard’s driveway. There’s no way he can convince you that stock returns of 6.5 percent per year over the next 20 years will make you more money than stock returns of 9.33 percent per year. And who wants stocks to plunge three years in a row, as soon as they start investing?
After walking around the block, you come back to the wizard’s place. Like a smug professor, he stands beside a huge piece of cardboard with several numbers on it.
“Those scenarios I gave you were real,” he says. The first scenario represented the 20 years from 1995-2015. The S&P 500 averaged a compound annual return of 9.33 percent. That period also started off with three big years. U.S. stocks gained 37.58 percent in 1995, 22.96 percent in 1996 and 33.36 percent in 1997.
“I would love to see a period like that again,” you say.
“Ah, but you might prefer the second scenario instead,” the wizard smirks.
“The second scenario represented the 20 years from 2000-2020. The S&P 500 averaged a compound annual return of 6.5 percent. And during the first three years, 2000, 2001 and 2002, U.S. stocks plunged 9.1 percent, 11.89 percent and 22.10 percent respectively.”
The wizard then pointed to the cardboard. It looked like this:
$10,000 Initial Investment + $1000 a Month
|Scenario 1||Scenario 2|
|Year||Year-end Value||Year||Year-end Value|
|Average annual return of the market||9.33%||Average Annual Return of The Market||6.5%|
|Money-weighted return for the investor||7.62%||Money-weighted return for the investor||9.95%|
The wizard must be off his rocker; you stare before trying to summarize the table:
“In scenario 1, despite the markets averaging 9.33 percent over 20 years, my money would have grown to $645,288, and in scenario 2, when the markets averaged just 6.5 percent per year, my money would have grown to $871,223?”
“That’s correct,” said the wizard.
“But how can that be?” you ask.
“Check out the money-weighted returns on this table. When stocks crash, you’re able to buy more stock market units at lower prices. It might take years for your money to recover, but when stocks soar, so will your money. That’s why young people should be thrilled when stocks crash, especially if stocks fall near the beginning of their investment journey. By paying a lower than average price over these 20 years, you would have earned a money-weighted return of 9.95 percent per year when the stock market averaged just 6.5 percent per year.”
You’ve heard about this before, at least the part suggesting young people should be happy to see stocks crash. But you thought it was urban myth.
“Based on this logic,” you ask, “Should I wait for stocks to crash before I invest more?”
“Plenty of people think like that,” the wizard smiles. “But trying to time the market is one of the worst things an investor can do. Almost nobody gets it right. And if they get lucky once, they try again. Eventually they fall in the…in the…in the poop?! Oh my, the lesson’s over. Get that dog out of here.”
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas
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