Young investors: This is the most important investment decision you’ll ever make
Reprinted courtesy of MarketWatch.com
Published: March 6, 2019
To read the original article click here
I was recently startled to learn that nearly one of every three millennials (generally defined as people age 18 to 37) believe the best way to save for retirement is to build up cash.
This news comes from a survey reported on Bankrate.com. The main reason young people want cash is their fear of stock-market losses like those experienced a decade ago by so many of their parents and grandparents.
Despite those very real losses, my message today is simple, yet extremely important: Young investors who avoid the stock market are making a mistake a that could cost them millions of dollars. Instead, they could wind up with millions of regrets.
In fact, I’ve come to realize that the single most important investment decision that most people will ever make is to invest in equities instead of cash and/or bonds.
Those who get this wrong will almost certainly regret it.
Fortunately, many young investors’ behavior is more rational than their stated beliefs. The majority of employed young people are participating in 401(k) and similar plans through their work, very often investing in target-date retirement funds.
Unfortunately, young people who truly believe “cash is king” and who don’t put their retirement savings into equities or target-date funds could eventually wind up in a world of hurt and regret.
Regret No. 1: Millions of today’s young people hope to retire earlier than the standard set by tradition (65) and Social Security (67 for their generation). Some are saving at extreme levels in a grass-roots movement known as Financial Independence Early Retirement (FIRE).
But if they invest in cash, they may have to continue to work much longer — maybe even forever — instead.
Regret No. 2: Cash-is-king investors who do manage to retire will likely have to live much more frugally than they would wish. Cash simply does not produce the growth needed to generate sufficient income in retirement.
Regret No. 3: Many millennials are idealistic, and admirably want to leave a legacy that they hope will help make the world a better place. But if their financial resources in retirement are barely enough to meet their own needs, they won’t leave much behind.
Regret No. 4: By the time they reach their 50s and 60s, people with inadequate retirement savings will start seeing many of their friends and contemporaries retiring and living much higher on the hog.
This regret will lead to perhaps the most anguished one of all:
Regret No. 5: By the time they discover that their resources are inadequate, these investors will realize — much too late — that the pain they avoided (no big investment losses in any given year) is dwarfed by the pain of permanently losing the opportunity to retire when and how they want to.
There’s no cure for this regret other than hoping for a winning lottery ticket or an inheritance. As Larry Swedroe once wrote, “Hoping is not an investment plan.”
Leaving all that cheery commentary behind, let’s look at more than 90 years of well-documented history to discover some cold, hard facts about cash.
Most people in the 18-to-37 age group have at least 40 years of investment performance ahead of them. Instead of looking at the money people lost in one or two years a decade ago, they should focus on what is likely to happen over a 40-year period.
Here are some facts about the 51 40-year periods that occurred starting in 1928:
•The lowest-risk fixed-income investment, 30-day Treasury bills, had an average 40-year compound return of 4.5%. That’s enough to turn a $1,000 investment into about $5,810.
•The lowest-risk equity asset class, the S&P 500 index SPX, -0.03%, had an average 40-year return of 10.9%, which would turn a $1,000 investment into about $63,800.
•The highest average 40-year return for fixed-income investments came from five-year intermediate term government bonds. That compound return was 5.8%, enough to turn $1,000 into $9,540.
•The highest average 40-year return among equity asset classes was 16.2% in small-cap value stocks. That was enough to turn $1,000 into about $405,000.
Think of the lifetime impact of those options. If you assume an investor made 20 one-time investments of $1,000, the outcomes range from about $116,000 (T-bills) to just over $8 million (small-cap-value stocks).
The less-risky S&P 500 index would generate about $1.276 million.
What does this do for somebody contemplating retirement?
If you assume a relatively sustainable withdrawal rate of 4%, the person who had made 20 40-year investments of $1,000 each would have a first-year monthly retirement income of approximately:
•$387 from investing in T-bills.
•$636 from 5-year government bonds.
•$4,253 from the S&P 500.
•$27,025 from small-cap value stocks.
These figures are based on average 40-year returns. Some periods were considerably better, some considerably worse. You can study this data more thoroughly in two tables: One for equities, and another for bond funds.
The implications of these numbers are overwhelming.
For one example: The risk-averse investor who chose 5-year government bonds would have to save nearly seven times as much to have the same retirement income as the investor in the S&P 500. Try selling that concept to your spouse or partner.
Some millennials who love cash may be so happy with their careers that they expect to work essentially forever. But they can’t count on that. One study found that 37% of retirees stopped working earlier than they had planned because of factors like job loss, health, or the need to care for children or parents.
Some millennials who love cash may be hoping for an inheritance from the same parents and/or grandparents who were battered and bruised by the stock market in 2008 and 2009. But that wishful thinking isn’t a good substitute for a realistic plan.
For more than half a century, I’ve been helping investors, and I’ve talked to thousands of retirees. Many times when I led workshops, I would ask for a show of hands: How many here are collecting pensions? (Lots of hands.) How many feel a huge sense of security from that pension? (Virtually all hands raised.)
Those pensions would not be possible unless pension fund managers had invested a lot of their assets in equities while the future beneficiaries were working. Had pension trustees invested in cash or short-term bonds, they could not have met their obligations.
Most millennials won’t have the benefit of a pension. They have to make the investment decisions for themselves. If they keep most of their money in cash or bonds, I think they will live to regret it.
Over a period of 40 years or more, even investing half your money in stocks will make a huge difference.
For more on this very important topic, check out my podcast “The most important investment decision of your life.”
Richard Buck contributed to this article.
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