If short-term volatility doesn't derail long-term growth, young investors should love market corrections.
Whenever stock markets plunge, the overwhelming reaction is chaos and anxiety. There are TV specials titled “Markets in Turmoil.” Headlines ask if now is the time to dump stocks. Perma-bears ramp up the boldness of their predictions, basically calling for the world to end.
Among these shouts is a growing chorus of whispers that corrections aren’t a cause for panic. Stocks have to go down every once in a while. Short-term volatility always ends up being a blip on the long-term price chart. And on and on.
These whispers are correct. But they’re hardly reassuring when the Dow drops 500 points in a few hours, and retirement accounts lose thousands of dollars. So the following charts illustrate the simple math behind this concept.
Opportunity for Savers
For retirees or other investors who don’t make regular contributions to their retirement accounts, there is no upside to a stock market decline. They’ve lost money, and aren’t in a position to take advantage of the decline. This is why retirees often shift a significant part of their portfolios to low-volatility asset classes and why others are encouraged so strongly to make regular contributions to their retirement accounts.
Assume the following scenario for a younger investor:
- He makes contributions of $20,000 each year; and
- Underlying assets will return at an annualized rate of 5.2 percent over a 16-year horizon.
If there were zero volatility in the returns — meaning that the portfolio returned exactly 5.2 percent each year consistently — the growth would look something like this:
Now assume a series of annual returns that results in an annualized rate of 5.2 percent but features significantly more volatility — the actual returns for the S&P 500 between 1999 and 2014. The value of the portfolio bounces around quite a bit, but ends up well ahead of the sans-volatility scenario.
The decline in the stock market in 2000, 2001, and 2002 were the best case scenarios for young investors just starting out; it permitted young savers to buy assets with tremendous long-term potential at a lower price. The huge decline in 2008 similarly created buying opportunities; stocks bought that year have nearly doubled during the subsequent recovery.
The important assumption in these scenarios is that the underlying asset will reach the same end point at the end of the time horizon. In the example above, that assumption is that the S&P 500 would increase from 1,229 at the beginning of 1999 to 2,085 at the end of 2014.
Put another way, this example assumes that the reasons for the short-term decline in markets do not alter the long-term trajectory — that in 15 or 20 years, the market will end up in the same place.
If that’s the case, young investors should be cheering for occasional corrections that create buying opportunities.
About the Author: Michael Johnston
Michael Johnston is senior analyst for Fund Reference, and also serves as COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.