Last Friday was 401(k) Day in the US, a day dedicated to retirement planning. We think 401(k) plans are great—a useful tool for those traveling along the most reliable road to riches: saving and investing well over the longer term. The occasion is also an opportunity to revisit some timeless lessons we think are particularly useful during a challenging year for investors.
Lesson One: Fathom the Power of Compounding
The max contribution to a 401(k) plan in 2022 is $20,500 (plus a catch-up contribution of $6,500 for those 50 and over), which doesn’t include any employer-matching funds. Of course, one contribution of $20,500 won’t provide for retirement. Moreover, not everyone can necessarily save that sum year in, year out. However, to the extent you are able, the combination of time and saving is critical to unleashing the power of compounding. Consider what a yearly contribution of $20,500 invested the instant the market opens on the first trading day of every year combined with an 8% annual return—a little below stocks’ historical average—can turn into over 30 years. (Exhibit 1)
Exhibit 1: A Hypothetical Illustration of Compounding’s Power
Source: Math and Microsoft Excel. Note, actual investment returns are highly unlikely to be this consistent and smooth, and we realize most people make regular contributions throughout the year rather than investing a lump sum contribution at the precise beginning of every year. We share this table strictly for illustrative purposes.
Lesson Two: Long-Term Returns Include Bear Markets
The S&P 500, which we use here for its long history, has an average annualized return of 10.3%.[i] That figure includes all the negativity over the past 96 years, from bear markets (typically prolonged and fundamentally driven declines exceeding -20%) and corrections (short, sharp, sentiment-driven declines of -10% to -20%) to pullbacks and daily dips—2022 isn’t an anomaly in that regard. Now, no individual investor likely invests with the next 100 years in mind. Most think in much shorter timeframes, so we understand concerns that one or two bad years can permanently set back a retirement portfolio.
But consider 20-year periods, which better resemble many current retirees’ timeframes. Since 1926, the S&P 500 has averaged about 5 negative years per rolling 20-year stretches. Yet no rolling 20-year period has been negative. The worst run (1929 – 1949) included the market crash of 1929, the ensuing Great Depression and World War II. Despite 10 negative years, that stretch’s average total return was 6.2%.[ii]
As we always say, the past isn’t predictive of the future, and it is always possible stocks deliver weaker—or even negative—returns over next 20 years. But making portfolio decisions based on historically unprecedented, possible outcomes isn’t wise, in our …….