Young Investors, Be Thankful for the Recent Market Crashes

If you invest for 30 years or more (lucky you — starting out early is one of the best keys to success[1]), history shows that you’ll experience at least two major market crashes[2]. But, the great news is that since just about everyone’s going to have to endure these rough times, taking them early in your life is significantly better than taking them later in life. In the story of our two identical investors Alice and Bob, everything is the same except for when their recession occurs — and as a result Alice ends up with 53% more assets at retirement.

Two Identical Investors: Alice and Bob

In our calculations, two investors Alice and Bob both start investing at age 35. Each year, they put away a constant $5,000 until they’re 65 years old and retire[3]. Everything about them is the same, except that they lived at different times in history. Alice retired in 1994, meaning that the stagflation of the 1970′s occurred in her thirties and forties. Bob, who is less lucky, retires in 1981 which means that the stagflation of the 1970′s occurred for him in his fifties and sixties.

The result? Alice retires with 53% more money. Alice has $360,792.90 at the end, while Bob has only $235,484.70 — all because of the timing of the major market crash in their lifetimes.

Why Annualized Returns Don’t Tell the Whole Story

We started with historical S&P returns* and extracted two thirty-year periods: 1965–1994 and 1952–1981. The U.S. experienced several recessions between 1969 and 1981 leading to a decade of stagnant market growth. We’ll use the two time spans to model experiencing a recession early in your savings timeline versus experiencing a recession as you near retirement. In the the following graph, we plot the return on $1 invested in each of the market scenarios.

Our critical observation here is that the total return over the 30 year period is actually better for the early-recession scenario (Alice). In particular, the late-recession scenario returns an annualized 4.92% compared to 4.13% for the early-recession scenario. But as you can tell, even though the often-quoted “annualized return” is higher for Bob, the average investor would much rather be Alice than Bob because his or her pattern of lifetime periodic invests would have done better in the early recession case.

Footnotes & Citations

  1. See our post on why starting to invest early is one of the best things you can do for yourself.
  2. We use the term market crash here loosely, because no good single definition of bear markets or market crashes exist. We chose not to use the term “Recession”, which is well defined by the NBER, because not all recessions are paired with bear markets.
  3. The returns were inflation-adjusted and accounted for dividend payments.
  4. Our portfolio allocation is based on the Morningstar glide path for an aggressive investor. As our hypothetical investor nears retirement, she incrementally rebalances her portfolio to be more conservative.

About the Author

By , on Jul 1, 2011
author
Josh Tokle a researcher at FutureAdvisor. He is a PhD candidate in Mathematics at the University of Washington, where his research focuses on probability theory and stochastic analysis. Prior to his PhD program he worked for the consulting arm of CB Richard Ellis, advising institutional clients on real estate investment decisions. Josh holds degrees in Mathematics, Computer Science, and Philosophy from the University of Iowa. He and his wife live in Seattle, where he plays the drums, keyboard, and sings.

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Leave Your Comment (3 Comments)

  1. @krantcents: It also depends on asset allocations. The later recession might not hurt as bad if you are mostly in bonds by the time it hits. The real hit comes from folks that are 100% dedicated to stocks and are about to retire.

    @Bartek: Yes, a great point. You have more time to recover from mistakes… and to learn from them, too.

  2. Bartek says:

    Starting out early is a great thing also because of collecting experience. It’s always a very important factor. Most of the people will make a lot of mistakes on the beginning (I did), that will be also good lessons for the future.

  3. Krantcents says:

    Timing is important, however the longer you are in the market the impact is less. Neither Bob or Alice will cash out on day 1. They will withdraw 3-4%, each can benefit from being in the market.

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