Wednesday, 4 March 2009

Playing With Numbers

(Alternative titles for this post: Why I'm screwed, Hoping for a lottery win, I should knee my financial adviser in the balls, Gawd - someone tell me I'm wrong!)

8%. According to my financial adviser that is the target growth for an investor. The double digit growth that the stock market saw in the 90s was not sustainable, and while those gains were nice, that kind of growth should not be counted on. 8% year over year growth, taken as a long term average, beats yearly inflation and grows an investment nicely. Once I neared retirement, the plan was to move into safe cash based investments that have a much lower rate of return, but are safer. Decrease my risk once the portfolio builds up.

This has been on my mind a lot lately. Today I decided to open Excel and do some amateur forecasting. I used the Dec. closing values of the Dow Jones Index, mainly because it has the most history available. It would have been nice to use the TSX, but it only goes back a few years.

I assumed an investor that started investing in 1978, and counted on 8% annual growth. I plotted their desired curve (the red line), and the actual performance of the DJI up until the close of 2008 (the blue line).

Click charts to embiggen.

Its very tempting to call the latest crash a natural correction, that the market returned to a more normal 8% return rate. That all depends on when you started investing. I went back to the DJI, and noticed the data went back to 1970. So I replotted the data assuming an investor that started in 1970.

What's the message? Timing is everything! From 1970-1978 the DJI saw a net increase of only 1.93% The 1970 investor had 8 years of poor performance, and had to play catchup. It isn't until 1996 that this investor starts realizing their retirement goals, and then 2008 hits and absolutely kills them.

Well history has a habit of repeating itself. This is the chart for an investor that hit the market in 1998 (like oh say, me).

What does this mean in real numbers? Lets take a 30 year period where an investor socks $5000 per year into market based funds, and indexes his investments to an inflation rate of 3%. (That isn't unusual. In companies that match your RRSP contributions, its all based on percentages. If you contribute 4% of your salary, the company contributes 4%. If your salary increases with cost of living at 3% each year, that 4% contribution will increase in step in proportion with your salary). Assuming an annual growth of 8%, after 30 years this is the investors expected return.

This is one of those charts that is supposed to convince you of the value of investing. Its easy to see why. After 30 years, $237,000 of steady constant investing has turned itself into $824,000.

Now what happens if the market "corrects" 10 years in, and you lose the first 10 years growth (and then resumes 8% growth afterward)?

That $237,000 has only turned into $681,000, a loss of $143,000. Ouch! That value after 30 years is supposed to be the source of your income after you retire. That difference may mean you cannot afford to retire when you planned to, or you may not be able to live in your home.

As I've said before. This downturn is going to reverberate for a long time. Its not just current retirees now that are affected, those of us in for the long term are, well, screwed. To cover the losses to my retirement portfolio I need another bubble even bigger than the last one.

And that's just not going to happen.

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