Retirement and the market sell-off

Posted by on September 16, 2011 @ 9:32 am in Retirement

When the stock market sells off, as it did in late July and early August, there is an inevitable surge in commentary on the riskiness of U.S. retirement accounts. The main worry is that retirement investors are taking on too much risk and that retirement assets should be invested in “safer” securities or programs.

From my perspective, many such criticisms seem unduly focused on the short run.

During the historic market downturn of 2008–2009, there was a great deal of attention to 401(k) losses from market peak to trough. Yet in the three years surrounding the financial crisis, 2007–2010, the median participant basically broke even in terms of investment returns. Over a longer five-year period, 2005–2010, he or she earned, on average, a positive 3.7% per year*. One important reason is that the typical investor doesn’t have his or her entire portfolio invested in equities, but instead holds a balanced portfolio.

To put it another way, despite a devastating decline in global stock markets, the typical participant broke even over three years and saw retirement wealth grow by almost 20% over five years (that’s an average 3.7% yearly gain compounded over the period), purely due to investment performance alone*. These effects are before considering the benefit of ongoing contributions to retirement wealth, which made accounts grow even more.

Yes, it is absolutely true that a 3.7% average annual return is subpar. Had 401(k) investors earned, say, 7% per year over the past five years, their wealth would be almost 40% higher, not almost 20% higher, solely as a result of investment performance. But the longer-term data demonstrate that this notion of widespread wealth destruction in retirement accounts is often mistaken.

Part of the problem is what is known as an anchoring and adjustment basis. There’s a natural human tendency to anchor our view of markets to the recent market peak. In effect, we reset expectations for our future account wealth in terms of changes from the recent maximum (and sometimes the recent minimum). But we’re better off spending less time focusing on the peaks and valleys—which represent extremes in market valuation and sentiment—and thinking more about long-term progress toward our personal account goals.

And this is precisely how we should think about more typical sell-offs in stocks as they occur, such as the July/August decline: Focus on progress over time, don’t anchor based on market peaks or valleys, and maintain a balanced strategy.

* See Vanguard’s How America Saves 2011, Figure 73, for detailed information on participant returns.

Note: All investments are subject to risk. Diversification does not ensure a profit or project against a loss in a declining market. Past performance is no guarantee of future returns.

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