A Better Way To View Stock Market Risk

(alternate title: Don’t Put Your Roth IRA into CDs or Cash!)

The prospect of losing your hard-earned money is scary. You know that if you invest with $1000 in stocks, in a year you could be left with either a huge gain or a huge loss. People (including me in the past) tend to look at the stock market like a slot machine:

Wrong Outlook

This is good in that, yes, for the short-term the stock market is risky. Don’t put money you may need right away into stocks. However, when young people tell me that they are putting their Roth IRAs in a bank CD because they are afraid of the stock market, that is bad. Roth IRAs are long-term investments. We’re talking 30, 40, 60 years for some people! The way you should be looking at the stock market is this:

Correct Outlook

As you can see, as your time-horizon lengthens, your risk of losing money decreases significantly. When looking back and taking any 25-year period between 1950 and 1994, the worse case still gave you a 7.9% annualized return. Note that the average for all of these time periods is still the same, 10% per year. So what you’re really looking at is something more like:

Not So Bad

Although we may not get that same 10% average in the future, I think it’s clear that you need to make your horizon as long as possible by starting now. Remember, even though you may track your investments daily, most of you are not going to actually touch them for decades, so it doesn’t matter what happens next year. What matters is that you were “in the game” for that year, extending your time period in the market, rocky or not. Also, this is just stocks – We are not even taking into the account the additional tempering effect of incorporating bonds to your portfolio.

Finally, consider this. Right now, bank CDs paying 6% in some cases may seem nice. But after inflation, the long-term return of cash-equivalents like bank accounts or Treasury Bills is… zero. By not investing in stocks (again, for long periods), you are giving yourself a 100% chance of making nothing. IRAs, 401ks, 403bs, TSPs, they are all for the long-run. Get in the game!

* The graph is adapted from one in A Random Walk Down Wall Street by Malkiel, one of my recommended investing books. Common stocks are defined as a diversified stock portfolio, such as the S&P 500 Index.

Comments

  1. Agreed! It’s so important to realize that there are 2 risks involved in long-term investing – 1. you lose your principal, and 2. your gains can’t keep up with inflation. It’s easy to focus on the first risk without paying attention to the second. Love the chart!

  2. This is a good explanation. I think I’ll use it in my new website.

  3. Hmm… I’ve been crunching some data and I was wondering… how are those annualized returns calculated for the 5 year periods?

  4. Nevermind.

    Here’s some poorly formatted data I calculated for the SV index from 1927 to today:

    YEARS 1 5 10 15 20 25 30 35 40
    MAX 141% 589% 1406% 2631% 5227% 12564% 25548% 58611% 83402%
    MIN -54% -81% -41% -14% 193% 482% 1329% 2785% 8610%
    AVE 19% 129% 378% 928% 2030% 4457% 9230% 17379% 36363%

    I chose not to annualize the percentages and just show the change (in %).

  5. The annualized return of the index is like 14%.

  6. Great explanation. Timely for us, as well, as we’re heavily contemplating our retirement portfolio, but it seems like in 30 years, everything will work out. I hope.

  7. Alex - YoungFinances.com says:

    Very good point. I just opened up my first Roth IRA (at E*Trade) so this is some good advice.

  8. This is an excellent way of looking at stock market risk, although including only the last 50 years makes the possible losses look better than they would if the 1930′s were included. For example, using the Dow Industials as the market index, the worst 25-year performance would’ve been -12% (-0.5% annualized) between August 1929 (Dow=380.33) and August 1954 (Dow=335.80). It’s comforting to look at the last 50 years and say that every bear market is followed by a bigger bull, but there was a time in our history where that wasn’t the case. As they say, “past performance is no guarantee of future results!”

  9. Love the graph. That’s a great way to put it.

    Now, People should first save a rainy day savings account before they “invest” in the stock market. Good article.

  10. i think the graph is misleading, there are periods you can find with losses from 10-20 year periods….but the idea is right

  11. When you are looking at returns, what really matters is real returns after inflation. For example, what Chris said about the 25 year period during the Great Depression is probably true if measured by stock prices, but it is an incomplete picture. During that time there was massive deflation (the opposite of inflation). Just as inflation erodes real returns, deflation would boost real returns. Compared to other investments, such as cash, stocks did realtively well over that 25 year period. If someone had the time to find the data, it would be neat to actually see a real-return chart similar to the one Johnathan posted above.

  12. Past performance is no guarantee of future results.

  13. It’s misleading that the data only looked at from 1950-1994, some of the greatest growth of the nation. If the data started from the 1920s, then the worst 25 year span would have been negative. Is the U.S. going to continue to grow as much in the next 50 years?

    Or take a look at the Nikkei. In a 20 year span from 1984-2004, it was also negative.

  14. I don’t agree that the graph is misleading. I just did my own analysis of the S&P 500 and a small-value index from 1927 to today. For the S&P 500:

    Lowest…
    5-year gain: -49%
    10-year gain: -10%
    15-year gain: 8%
    20-year gain: 80%
    25-year gain: 308%
    30-year gain: 1010%
    35-year gain: 1663%
    40-year gain: 2741%
    45-year gain: 2404%
    50-year gain: 3737%
    55-year gain: 8369%
    60-year gain: 17111%

    These are not annualized (they are cumulative), and they are not inflation-adjusted.

    By the way for small value, the worst period gains were:
    I don’t agree that the graph is misleading. I just did my own analysis of the S&P 500 and a small-value index from 1927 to today. For the S&P 500:

    Lowest…
    5-year gain: -81%
    10-year gain: -41%
    15-year gain: -14%
    20-year gain: 193%
    25-year gain: 482%
    30-year gain: 1329%
    35-year gain: 2785%
    40-year gain: 8610%
    45-year gain: 6708%
    50-year gain: 20516%
    55-year gain: 71739%
    60-year gain: 132852%

    I don’t think these numbers are statistically comparable because there are many more rolling 5-year periods than rolling 60-year periods, for example.

  15. This is probably good advice for the masses, but not if you are trying to time the market. There are always periods of ups and downs. After a long run it is typical for some kind of downward trend. In other words: it would have been much better to have been in CDs and treasuries in the couple of years following beginning of 2000.

  16. excellent analysis, and perfectly illustrative for someone who is investing in a target retirement fund (trowe) and letting it coast. you would think these are the same data sets that fund managers and employees are using to develop their strategies to target return. Nice post for those of us that don’t have time to “time” the market.

  17. People should definitely diversify between domestic and international stocks to maximize the risk/return.

    Annualizing DM’s numbers for the S&P 500 since 1926-now: Lowest 30-Year gain of 1010% = 8% annualized.

    I totally agree that past performance is not a guarantee of the future. However, we are not talking about the 1-year performance of some hot fund here. All any of us can do is put our money in the place that has the best chance for success. And by examining 80 years of data, we can gain much more confidence.

    The narrowing of the range bands as with the increase in time periods (or reversion to the mean) has been true since stock prices have been tracked. While the numbers may be different depending on what specifically you are looking at, the reduction of risk with time remains.

  18. Bronco, hindsight is 20:20. There is no way to time the market. Being in the market 100% of the time will beat all other strategies.

  19. DM, that is untrue. Have you not heard of asset allocation?

  20. Stocks are the best long-term investments, especially small-caps.

  21. I have a question, I have money sitting around, I want to buy my first house, but my money is in a 4% savings account…I hear all this talk about stock market, mutual funds, what is the best idea to make nice appreciation for about 2 years so I can take that money out?

  22. No one can time the market but there are some moves which can be made to improve your odds of having success. When rebalancing your portfolio or when investing new money, the natural tendency is to buy more shares of the “high flyers” and sell shares of the “losers.” This strategy is inviting disaster.

    Remember to buy “low” and sell “high.” If your small cap holdings have soared, it might be wise to divert a portion of the earnings into an area where you are under invested–ie. large caps.

    Avoid excessive buying and selling.

  23. Ryan Whiteside says:

    This is an excellent point that people need to understand. Things might be rocky with the stock market in 1-5 year stretches. But if you look at the stock market in ten years intervals, every time it goes up. It may be a little or it may be a lot, but it always goes up. And, chances are it’s only going to continue to do the same.

  24. It is interesting to note that if you measure risk by the volatility of end balances, the stock market is actually RISKIER the longer you invest since a 1-2% per year difference in return can make a huge difference in your final balance over 40 or 50 years. It’s all about perspective.

  25. OK – I understand that stocks are the way to go for the long term…but what about the short term when the market has tanked?

    For example, if my 401K was worth $100,000 on Jan 1, 2008 and on July 1 it is only worth $85K, shouldn’t I pull out half of the remnant and put it in a CD or bond that gains SOMETHING (even 3%?) for the next 3 to 5 months? And then put it all back in the market ?

    Thanks -

  26. Mike DeZonia says:

    Explain to me, if I have 60,000 in the stocks and its down 15,000, where is this lost money? who has it? how does it grow back?

  27. ngân hàng says:

    Really?

    Do you look at the Top 10 “miss forecast” of NYT ?

    I not believe any more on the market.

  28. Yeap. Time is the main factor in everthing.
    In fact, we could just look at life in this same perspective.

    Any moment of failure is nothing but platform for greater success in the eyes of time.

  29. Extremely Flawed!!!!

    You’re analysis is extremely flawed for many reasons. Most notably you don’t take into account the survivorship bias inherent in an index like the S&P 500. In other words, the tendency for failed companies to be excluded from the index performance due to the fact that they no longer exist. By not considering the survivorship bias, you greatly overstate the returns and grossly understate the risk involved.

    Consider this sobering statistic: Of the five hundred largest U.S, Companies in 1957, only 74 were still part of that select group, the Standard and Poor’s 500, forty years later (The Black Swan by Nassim Taleb).

    If this does not make you queasy about investing in the “promising” stock market, I would suggest having your head examined.

  30. Willy Wonka says:

    Why are you using charts and data from 1950-1994??

    That’s a 44 time period that only includes a post war bull market. Without the Great Depression, the Dot Com Bubble or the current financial crisis, this data tells us nothing.

    Actually, people investing their own money in the market or just buying index funds or mutual funds is a stupid idea, but instead of giving us reliable data, you just pulled data from a 44 year period… that’s too short of time period to be reliable and is definitely not predictive of the future of America or the US Stock Market….

  31. Please update! Is it possible for you to update the information through 2010? I think the data would be more relevant.
    Thanks!

  32. Jonathan, I agree with Chris that it would be great to see this chart updated!

    However, I did find this similar chart, which covers S&P 500 returns from 1973-2009:
    http://moneyover55.about.com/o.....eturns.htm

  33. I love this post, but I think there is just too much to consider, factor wise when it comes to average return. The big picture point is there though.

    Great Article.

  34. Can you update this?

  35. To place this in a universe of alternative outcomes, it would be interesting to see these calculations applied to the Nikkei index over the same period of time. You may in fact reach the same conclusion but the volatility between 1985 and 2005 might provide insights for possible future outcomes. This site can be used for the data:
    http://indexes.nikkei.co.jp/en/nkave/archives/data

    At the end of the day it is all a risk vs. reward equation. The 10 year treasury can be used as a benchmark for what Mr. Market is currently pricing very low risk at.

  36. The risk in all of this is assuming that the future of the US market will be like it’s past, and not like the past of another market. For example using the Nikkei 225 from 1950 to the present you would get:

    1 year -39.7 to 116.11
    5 year -10.26 to 63.39
    10 year -5.57 to 122.88
    15 year -4.69 to 85.91
    20 year -3.64 to 103.65
    25 year -2.20 to 166.76

    Do you then reach the same conclusions you reached with US market data?
    Is there a reason to believe what happened in Japan could never happen here?

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