Stock Market Facts

Conventional investment advice depicts investing in the stock market as a game you will always win if you do two things: first, diversify (using mutual funds); second, hang on (never sell). If you can do these two things (so the story goes) you will be rewarded over the long-term with higher returns than average - in the neighborhood of 10% annually.

This advice is dangerous to your financial health and to your successful retirement.

As a long-term investor, you cannot afford to be fooled by what is called "the money illusion". The money illusion is thinking about returns in nominal terms, rather than in inflation-adjusted terms. Over the past 80 years, the "average" inflation rate has been 3.5% per year. This is the return you must get over time just to stay even in terms of your investment's purchasing power. Over the "long-term", however you define it, you must beat the inflation rate by 5% to 8%, if you expect to grow your assets into a sufficient capital base to provide lifetime income during retirement.

There is no such thing as the "average" long-term return of the stock market. There are long stretches of time when the market does very well. The time period from 1981 to 2000 was one of these times - it was the longest and strongest bull market ever. Holding the S&P 500 continuously during this 19-year "boom", yielded an average annual return of about 17%.

There are also long time periods when stocks do poorly. From 1901-1921, a twenty-year span, the stock market returned about 0% annually. Adjusted for inflation, the market fell 40% over the first two decades of the 20th century.

The fact is that the U.S. stock market went through three major bull markets in the 20th century (1921-1929, 1949-1968, 1981-2000). The remaining years, about 50% of the time, were "hangovers" which corrected the excesses of the "boom" years. You can see this clearly in the chart below, which shows the long-term (since 1871) behavior of the S&P 500 adjusted for inflation.

Conventional investment advice to stay substantially and continuously invested in the stock market works during long-term bull markets, like 1981-2000. But, as you can clearly see from the chart, it is a poor investment policy the rest of the time.

Today, the evidence suggests that we are not in a long-term bull market, but rather in one of those long, drawn-out corrective "hangovers". To prosper under these conditions, means paying special attention to risk management. The 401(k) Formula^TM does just that by limiting exposure to the stock market to well-defined time periods when the risk of a market decline is substantially lower than normal.