For long-term investors, knowing the difference between what they can and can’t control is often the key to both financial success and peace of mind. While investors would like to believe they can predict or even control the market, experience teaches us that this is difficult to do. Constructing and managing an appropriate portfolio, while making strategic and tactical allocations, ideally with the guidance of a trusted advisor, is often the best approach. However, while following markets and maintaining perspective on the economy is important, the fundamental keys to success are primarily to start saving early, stay invested, and remain focused on your long-term goals.
The growth of an initial $1 investment over the last century has been remarkable.
Staying financially disciplined has never been more important. With the sheer volume of noise from the media and the financial services industry, it seems as if headlines bounce from one concern to the next every week, with markets swinging from exuberance to distress! For inexperienced investors and financial professionals alike, this can sometimes be overwhelming.
The reality is that this is nothing new. In 1979, for instance, the cover of BusinessWeek famously proclaimed "the death of equities" due to inflation - just as many did last year. In the short run, this was correct as markets pulled back due to economic shocks and recessions. However, both the market and economy eventually recovered. Not only has the market experienced strong returns this year, but the past forty years since that magazine cover was published have been some of the best in history!
This pattern plays out when looking back even further to 1926 when analyzing the performance in stocks and government bonds. A $1 stock investment almost a century ago would have grown to over $13,000 today despite the numerous challenges along the way. Even when invested in more conservative government bonds, the value of that dollar would have climbed to $98. In comparison, inflation has eroded the purchasing power of cash, with $17 now needed to buy what $1 used to in 1926.
What this illustrates is that over time, the stock market has created significant wealth for patient investors. However, bonds are also needed to smooth out the bumps along the way in order to preserve wealth. A proper asset allocation that takes advantage of both asset classes, and possibly many others, is often the best way to navigate turbulence while positioning for long run growth.
What's just as important, and fully within an investor's control, is when they begin to save and invest. For example, an initial $1,000 investment, compounded annually at 7%, can hypothetically grow to over $10,000 by age 65 if the investment is made at age 30. If it's instead invested at age 35, only 5 years later, the investment will only grow to about $7,600. The power of “time in the market” vs. “timing” the market is an easy concept to see.
While investing is viewed as the activity of following markets, economic data, stocks, and current events, this underscores the fact that budgeting and planning are equally important. After all, investors don't get to choose whether they live in an era of low or high annual returns. However, investing at age 30, instead of age 40, makes just as big a difference as experiencing a 5% or 7% annual return over the course of one's life.
The compounding effect of investments requires time.
This is because the compounding nature of investments can only work if there is a sufficient period of investment. Given enough time, not only do investment returns add to a portfolio, but those returns generate their own returns, and so on and so on. In this way, compound interest is what creates true wealth for investors over long periods of time.
The rule of 72 is a simple way to understand this compounding effect. It is a rule of thumb that estimates how quickly a rate of return would lead to a doubling of a portfolio, or similarly, what return is needed to double a portfolio in a certain amount of time. For example, with a 5% to 10% annual rate of return - a range consistent with long run historical returns - a portfolio would be predicted to double in 7 to 14 years. Thus, starting early creates more opportunities to benefit from this effect. Of course, while the rule of 72 is based on pure arithmetic, markets can vary wildly on a week-to-week or month-to-month basis. The examples above are hypothetical in nature and for illustrative purposes only.
The bottom line? While investors should understand and maintain perspective on the market and the economy, it's equally important to invest early and stay invested through challenging times. History shows that this has been the best way to achieve long-term financial goals.