When you’re investing for goals, like retirement income, that may be many years off — it can be easy to lose sight of those objectives and become distracted by what’s happening at the moment.
Nothing provides investors with a better opportunity to make this mistake than market volatility. Your investment portfolio has been growing nicely and fairly steadily for years and then, for no clear reason and without warning, its value falls — far and fast. One day, you felt good about your TSP’s prospects for supporting a nice standard of living in retirement, and the next day, your confidence has been crushed.
“My retirement plans are ruined” goes the refrain. I heard it during the market crashes of 2000 and 2008, and I’m starting to hear it again today. But, any good retirement plan that was formulated before either of the last two crashes should still be on-track today, and it will still be on track tomorrow. For these plans, the news of their demise was greatly exaggerated. One of the things that investors often overlook when they fear the effects of severe market downturns is that time is a key factor in investment performance. Along with periodic rate of return and volatility of returns, time actually helps to define investment performance, and to determine wither, or not, your retirement plan will ultimately succeed.
Investment returns are calculated and defined based on periods of time. Think of time periods as trials in an experiment. I’ll use coin flipping as a parallel example, to explain what I mean.
Let’s say that you develop some plan of action that depends upon the probability of flipping heads being 0.5, or 50 percent. Since the coin is a balanced, symmetrical coin, the probability of flipping heads is actually 50 percent. You’re going to flip the coin every week for 20 years, and at the end of that period, your action plan’s success will be determined by how close the total number of heads flipped is to 50 percent of the total number of flips. Over 20 years, you’ll flip the coin 1,040 times, and your success will depend upon how close the total number of heads is to 520.
You start flipping and keeping count. At the end of the first year, you have flipped the coin 52 times and it has come up heads 47 times. That’s about 90 percent of what you should have expected, and things are off, but not by a lot. Then you flip the coin another 52 times in year two and add 25 more heads to the total, which is now 72 out of 104. Now, you’re worried. Your experiment’s performance is lagging reasonable expectation by more than 30 percent. If the trend continues, your experiment will fail. Even if it doesn’t continue, something seems very wrong. You must have miscalculated and maybe your experiment is doomed to fail, whether things improve or not.
Although this is a very common human reaction to underperformance, in just about any setting, it is based on emotion rather than reason. There is risk in the coin flipping outcomes and they are likely to deviate from expectation, particularly in the short run. The fewer the flips, the greater the risk. If you flip the coin five times, it is not that unlikely that all five will come up tails. If this is all the experience you have, it will appear that the probability of flipping heads is zero and your expectations were unreasonable. But, the probability of flipping all tails in 100 flips is so remote that it might as well be zero. Flipping 1,000 tails in 1,000 flips is even more unlikely, yet. In fact, the more times you flip the coin, the more likely you are to come up with the expected outcome of 50 percent heads and 50 percent tails. This is called the Law of Large Numbers in statistics and it’s important for every investor to understand.
Invest over 20 weeks and just about anything is possible — like 20 straight weeks of losses. But, invest over 20 years and the range of likely outcomes narrows considerably. This means that the short run aberrations that seem so threatening, or fortuitous, are likely to be counterbalanced and suppressed by future outcomes that will tend to bring the performance into line with the reasonable expectation.
When your fear of uncooperative investment markets is high, try to remember that one bad day doesn’t make a year, and one bad year won’t ruin a good retirement plan.