Oct 27, 2008

the math hurts

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What is the name for what’s going on with the economy these days? We’re still technically not in recession and I think shrieks about a depression are overdone.  A crisis?  Whatever it is, it continues and I see no signs that it will abate before long.

I had managed to stay calm about the crisis even after seeing my investment and retirement accounts (IRAs) stagger. I work on Wall Street, so I’ve seen the bloodbath in the workforce – people who worked in accounting or IT who had nothing to do with the idiotic ponzi schemes got axed.  Times are tough, and from an objective viewpoint I understood that.

Here’s what brought it home for me. I have a 401(k), and the company it’s with has a nifty little feature to calculate “real” return; returns with the matches, contributions and so on factored out so you only see the return on what was in your account.  Up until 2008 I had been running at a slightly-disappointing-but-tolerable 8% per year return.

From my point of view 8% on a tax-free return is not a bad return, but in the heady market froth of the last few years it seemed less than exciting. I had managed not to worry too much about my 401(k), but I finally broke down and checked it Friday.  The result?  This year, down 65%.  My portfolio in my 401(k) is dull:  S&P 500 index funds, a midcap index fund and a euro-pacific index fund (plus I have a bit in stable value, about 5% of the total).

That alone wasn’t enough to bother me, but this was:  the standard assumption in the personal finance world, based on a lot of historical stats, is that a 10% per year return in the stock market is reasonable and expected for retirement planning purposes.  At first glance, that seems to be reasonable.  10%?  No big deal.  But here was the kicker, for me:  it takes 11 years to restore a 65% loss to breakeven at 10%.

I need to make 10% per year for 11 years just to get back to where I was in 2007. Is there another dot-com run-up somewhere in the future, when the market will surge 20%, 30%?  Keep in mind I’m talking about index funds, so the return is based on the market as a whole, not an individual stock where the possibility of a 30% rise is greater (although the possibility of a 100% collapse is also greater).

I’m not saying this to discourage anyone from investing in index funds, but it is a brutal reminder that you are not “investing” in index funds:  you are SAVING. I have some spare cash and I’m tempted to put it towards individual stocks rather than index funds when I look at those breakeven numbers.  11 years of great returns to break even?  Whee.  If you ever needed a reminder why you shouldn’t put ALL of your savings and investments in the market, thinking about the math on losses should be enough to keep you scared straight.  It takes a 100% gain to recapture a 50% loss…

Creative Commons License photo credit: Petrick2008


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  • Richard
    If you're not comfortable with investing, it's ok to just buy bonds.

    Looking at single stocks? The drop in the indexes may be bigger than anything that's happened in a long time, but every year countless individual stocks perform the exact same maneuver as they run into their own problems.

    It may seem wrong that it could take 11 years to get back to the same level as last year, but the long-term average 6.5% real return of stocks happened through times worse than these. When I was learning about investing last year I kept thinking "if only you could avoid all those bad days in the market you could do a lot better".

    I finally got the point that if you see things that way the market will hurt you again and again, but if you accept it as part of the process you can make money. Above all, the stock market is not a smooth progression no matter where you look.

    There's two important things to remember that no one wants to talk about:

    - A "recovery" to last year's prices means absolutely nothing if those prices weren't based on meaningful long-term economic advantages

    - The last few months may be the best thing that's happened to future returns in the last 20 years
  • Joe
    I'm not a Wall Street analyst, but isn't the 10% ROI based on long-term averages? Therefore, wouldn't it include "bad years" like this? Meaning, if you look at the year-by-year ROI, you'd likely see most years at 11-13%, but the down years wipe out much of that ... umm... surplus return.

    I dunno. It seems that labeling 10% as a "good year" without acknowledging that it is derived from the long-term annual average rather than a median or mode is misleading.
  • Joe, it might be a bit misleading - I just mean that even at 13% it takes a long time to rebuild a loss that significant.
  • If you are down 65% you need to revisit your asset allocation. As for the 10% rule of thumb for long term geometric mean returns, that went out the window before the current crisis.
  • Richard
    If you hypothetically bought an imaginary stock in a fictitious country for $1500 when it was really worth $900-$1000, getting a 10% return would be much, much less likely than if you bought that same imaginary stock for $800. If that stock somehow went down to $700 as you waited (because the stock was being held by martians who were prone to throwing out reason and logic and selling based on emotion alone) and you bought it then, your future returns would look much better. In the very unlikely event that something like this were to happen, you might enjoy the reduction in the price because it made possible returns that you had thought weren't possible due to the (previously) high price. But that's just a story with no basis in reality :)
  • Richard, you're closer to the point than I was. My mistake was buying into the market when it was overpriced - not my asset allocation, or the amount or anything like that. If you buy an $800 asset for $1000, you're going to lose eventually.

    It's the biggest weakness of 401(k)s, in my opinion - limited choices and an emphasis on buying on schedule rather than when ideal.
  • I need to read stuff like this - my latest consulting contract is ending soon and with the financial services industry crumbling in NYC I may be problogging again real soon…
  • Mr. TML, absolutely - my asset allocation in my 401(k) is harshly, HARSHLY limited by the choices available. My asset allocation is not in funds I would choose in an open market. Of course that begs the question of why I'm investing in my 401(k) at all, and I'll beg the usual excuses: matching, tax advantages, etc. All wiped out by the loss, of course...
  • It would take 11 years at 10% to get back to where you were, if you were to stop buying. If you keep buying, those 10% gains on your new contributions would reduce the time period needed to catch up.

    A 65% loss is pretty brutal, but if it had to happen to you, it's better to happen now when you have many years of stock buying ahead of you, right?
  • My portfolio sounds similar to yours: index funds of the same exact kind almost. I'm also curious how you are down 65%. Did one particular fund slow you down more than the others? It sounds like we have similar allocations but I'm not down nearly that much.

    Either way, I wouldn't be worried. Let's just keep plowing more and more into it.
  • WC, I'm plowing more into it, trust me - I upped the contribution percentage and I'm hoping that future contributions beat my losses. I had two funds that slaughtered my returns, and one in particular (a mid-cap fund) has gone to almost worthless. My 401(k) doesn't offer a good mix of index funds, mostly managed junk, so I take the blame for not going super-conservative with the 401(k) and putting the risk in my IRAs and brokerage where I have more control and choice.

    I'm not TOO worried - I'm young, I have time to recover. I hope...
  • Thank you. You just put in a nutshell what I've been trying to explain to my friends who can NOT understand why I'm in a blue funk.

    In 11 years I will be almost 75 years old.

    I had planned to retire in a year or two. Now -- assuming the rumors of layoffs at my employer's shop don't come to fruition -- I likely will not retire. Ever. This situation has already left me totally screwed, and it's far from over.
  • katy
    do you really think we'll ever get 10 percent?
    6 is more reasonable. factor in taxes. we're
    all screwed.
  • jim
    Hmmm that is a sobering thought though... 11 years just to make it back to 2007? Wow.

    You have the unfortunate luck of being whalloped by equities AND international because of the dollar strengthening (or should I say, other currencies weakening faster than we are)... yikes.
  • I feel confident that there will be one or two more bubbles and crashes before my retirement at the very least. I'm just not planning on overexposing myself to any of them.

    If this crisis is anything like the depression it'll take about 18-20 years for your stocks to recover. On the bright side things that you buy during that time will be cheap and rise in value.

    Of course it could all end up like Japan and just stay flat for years and years. Not every stock market in the world averages a positive return over the medium to long term.
  • i am thinking that the point of "long-term" is also that it's not about putting in money at time X and not touching it for 30 years, but to continuously invest over 30 years. So the funds that you bought before and are down now will take a while to recover. But if you bought the same funds now, they'll see some exponential gains in the next 30 years. I guess over time, it all evens out.
  • @ Richard: Bonds in many cases don't perform well after taking the rate of inflation into account, let alone the REAL rate of inflation. Corporate bonds are far from 100% safe in most cases, as has been found out recently.

    I prefer to invest in individual companies because I'd rather invest my money into great companies I understand (in my circle of competence) than invest in ALL companies, many of which are poorly managed or capitalized. I don't want 'average' market returns either... I invest in businesses, not the entire economy and will settle for the returns I get, which I think will be better than the overall economy... if not, so be it. At least I'm comfortable with my investments and with any drops or rises in their valuations. I know when the price goes down below a certain point, my company is undervalued, and when it goes above a certain point, its overvalued... So when the value goes down, many on Wall Street freak out, but I might be sitting there buying more shares in a PARTICULAR company that I know is being thrown out with the bath water... even if the economy has a grim outlook for a few years...

    The real problem is the REAL rate of inflation in regards to your returns. Then taxes come into account afterwards.
  • If you are buying more shares now, perhaps the dollar cost averaging helps a bit.

    Lately, I've been wondering if the 8-10% expectations we've had is sustainable long term. If you think about it, stock prices are related to earnings. How can earnings of companies grow 10% each year if wages aren't growing (i.e. you need people to make more to be able to buy more products or pay higher prices). I don't think wages haven't been growing at 10%, but historically we've added another income (largely women entering the workforce and making larger salaries) and living on more credit.

    If those two things were what lead to the big historical gains that may be a problem in the future. We aren't adding more incomes to our families and living on credit doesn't seem to be the option any more.
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