The stock market can be a fickle friend to long-term investors. One year your investments produce spectacular returns, while the next year you lose all your gains.
The problem for the long-term investor is achieving a goal that may be 20, 30 or more years down the road.
As noted below, the math is relatively simple. What is not simple or predictable is how your return can fluctuate from year to year.
By one measure, the market (using the S&P 500) was:
- 2007 - up 3.5%
- 2008 - down 38.5%
- 2009 - up 23.5%
- 2010 - up 13%
- 2011 - flat 0%
As you can seen planning for long-term goals is difficult.
Compounding. is the long-term stock investor's best friend. While the power of compounding is remarkable, it can created the illusion of security when used in long-term planning.
Long-term stock investors may fail to consider the limitations of compounding when laying out a plan to reach a future goal (retirement, for example).
The basic calculation for long-term planning is: If I invest $X per month for Y years and Z% return. Many investors work this problem back from the goal: If I want $A in my retirement account, how much do I have to invest per month to get there given my age.
Two problems in particular can sabotage a long-term stock investor's plans. The first problem is the market never hits consistent returns from year-to-year.
Many projections use a historical average return for the market of 8% to 10% and stock investors often plug one of these numbers into their calculations.
This can lead an investor to assume a constant rate of return on their investments that won't materialize. If you don't make annual adjustments to your plan based on actual performance, you may or may not reach your goal.
This means you need a 30-year plan in year one, a 29-year plan in year two, a 28-year plan in year three and so on.
You can control the amount you invest, but you have little or no control of your return from year to year. Your plan must be constantly adjusted to the realities of the previous year and current market trends to provide a realistic picture of how close you are to being on track to achieve your plan.
The other problem with long-term plans has to do with the math of compounding. The largest growth in real terms occurs at the end of your long-term plan.
That's because your account balance has, hopefully, grown to a significant size and compounding produces more in terms of real dollars gain.
For example, if your balance is $1,000 and you hit a 7% return the real growth is obviously much less than if your balance is $500,000 and you hit a 7% return.
The practical effect of this is that the last years of your long-term plan must produce consistent gains to achieve your goal. If you don't hit your returns during the final years (7 to 10), you will not reach your goal.
As you approach retirement, a bad stretch of market lows can sabotage your best plans, as many discovered following the financial crisis of 2007-10.
Your safest bet is to achieve most of your goal before approaching retirement years, when you should be more concerned about preserving capital than growing it.
A volatile market at the wrong time can be a disaster. Don't bet your retirement that another financial crisis won't happen just when you need stability in the market.