There are a lot of interesting charts for investors, but there is one very powerful that illustrates most principles of retirement planning. If you interpret this chart correctly, you will understand the basis of portfolio allocation theory. You’ll be in good shape if you combine this knowledge with some discipline to build an investment strategy.
Back across different time periods
This graph displays the percentage frequency of positive returns across different trading periods throughout the history of the stock market.
The graph indicates that in approximately 70% of cases, the stock market has risen during any four-month period. This frequency rises to 80% for two-year windows and 90% for six-year windows. This general upward trend continues all the way up to 16 years, after which the stock market has not caused a net loss.
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We can conclude that stocks are a safer bet for growth over long periods, while shorter periods are less predictable. Over a sufficiently long period of time, there is no historical precedent for negative returns. This may sound like a simple observation, but it has major implications for retirement investing strategies and portfolio building.
What is the reason for this pattern?
Trends and past performance are not necessarily indicative of future results, but it is important to consider the forces that have driven returns throughout history. It is no accident that the graph takes its shape.
Think about the forces that determine a company’s value. The value of a stock reflects how much people are willing to pay for it at any given time – this is the basic supply and demand. In turn, supply and demand are influenced by capital market conditions in the overall economy, along with the cash flows that investors expect the company to produce.
If the company is going to generate more profits than expected, the business is worth more to the shareholders who can get those profits. Stock prices are also driven by things like interest rates, inflation expectations, and investors’ risk appetite.
As a result, there is a difference between short-term and long-term motives for stock values. The market as a whole should grow along with the global economy. Employer hiring, consumer spending, and entrepreneurial innovation increase economic activity. This increases the amount of cash flow companies produce, and ultimately translates into higher stock prices.
Things can get quite messy in the short term – just look at the major financial crisis, the internet bubble, or the COVID-19 pandemic. However, the global economy has a recurring tendency to remain tense if we give it enough time.
What does this mean for retirement planning?
This tells us a lot about growth and volatility, and is essential information if you want to build a successful retirement portfolio.
History tells us that volatility is not a huge risk over periods of 15 years or more. If you have a long time horizon – and the discipline to continue investing during periods of market downturn – you can invest with confidence to grow. A diversified portfolio with high exposure to stable growth stocks is a powerful tool for young people investing in a 401(k) or IRA.
On the other hand, negative returns are fairly common for the shorter time frames. Sometimes these losses can be very severe. All kinds of strange and unexpected events have led to corrections and downfalls throughout history. Investors with shorter time horizons cannot necessarily afford losses. If you are less than 15 years away from retirement, you need to take steps to protect your investment portfolio. As you move into your 50s, it’s time to start locking in some gains and increase exposure to bonds, dividend stocks and other asset classes with lower volatility.
If you follow this formula, you will greatly improve your chance of making responsible long-term gains – and reduce the risk you would lose in the event of a market downturn.
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