Here are two doors you can walk through:
Door number one – you spend 15 years putting $1000 into an investment every month, with the possibility of seeing that investment get cut in half twice.
Door number two – you spend 15 years putting $1000 into an investment every month, with the same annual performance of what’s behind door number one, but no drawdowns.
Which would you choose?
On the surface, you’d choose door number two. Of course you would, who wouldn’t?
But it’s the wrong choice. The trick here is to remember that you’re adding to the investment at a rate of $1000 per month. That’s when you realize that door number one, with it’s twin 50% crashes, is the better option.
It’s the harder choice to live with, of course, but that’s what the money’s for. Had you done this over the disappointing period for stock returns between 2000-2014, you would have lots of money to show for your troubles. Much more money than had you chosen the steadier option.
Eric Nelson at Servo Wealth explains how this is possible, by looking at an investor who chose to buy $1000 worth of the S&P 500 each month over the 15-year period versus the investor who chose to buy the more stable Vanguard Short Term Bond Index.
Despite only saving $180,000 cumulatively, your total ending portfolio value was $352,202—twice as much as you saved—for a rate of return on your contributions of +8.5% per year! How can this be? The S&P 500 only averaged +4.1%. But not all of your savings averaged 4%. Some money went in after 2001 and 2002 and 2008 and 2011 when shares were extremely depressed and subsequently earned returns of +12%, +15% and +20% or more…
We can see the opposite effect when we observe the outcome of dollar-cost-averaging the same amount into the low-risk bond fund. Remember, it had the same annual compound return over the 15-year period. But the amount of accumulated wealth was only $228,294, almost $130,000 less than what you netted from the S&P 500.
Josh here – The magical part is that the two investment choices both did around 4.1% annually on average. But by taking advantage of the short-term declines – systematically (which is the key) – investors can learn to embrace the volatility that ends up punishing some, but rewarding others with higher than average returns.
Conditioning yourself to love drawdowns is not easy – and the more money you have at risk, the harder it is. Younger people with 401(k) plans and newer brokerage accounts can use the power of DCA (dollar cost-averaging) – this is one critical advantage they have over their parents and grandparents. If they take advantage of it, the magic of compounding doesn’t take very long to appear.
Don’t flee from volatility, understand how it helps you and make it your bitch.