A Trip in the “Wayback Machine”

Behavioral Finance
Inflation
Risk vs. Volitility
History
By
Sarah F. Roach, Vice President

It’s not uncommon for investors to feel anxious about volatility in the stock market—generally expressing their anxiety in terms of “risk.”  Amidst the recent stock market turmoil, some investors sold their stocks, thinking, “I can’t afford to lose this money—it’s my retirement!”  No one wants to “lose” their money, of course, but letting short-term volatility scare you out of long-term equity investing can be doing just that—sentencing yourself to losing money/purchasing power.

This situation spurred me to take a little trip in the time-travelling “Wayback Machine.”  (Anyone remember Peabody and Sherman from the 1960s cartoon, Rocky and Bullwinkle?)  I wanted to witness how “safe” it would have been years ago to avoid the stock market’s volatility, so I set the Wayback Machine for 1967.  In that year, my parents built a two-story home for $36,000, and the average new car cost $2,750.  Nowadays, the average new car costs just a little less than my parents’ home did (about $31,200 according to truecar.com).  I’m sure this is not news to most of our clients.  In fact, most of us have played the “what-did-things-cost-back-then?” game from time to time.

While back in 1967, I encountered a young couple who were deciding whether to invest $36,000 in the stock market or stash it under the proverbial mattress.  They reasoned that they couldn’t risk “losing” their money, so they squirreled away cash, comforted by the knowledge that when retirement came around in 40 years or so, their $36,000 would be there to help contribute to a comfortable lifestyle.  (Nowadays, savings accounts and CDs are not much more lucrative than putting cash under a mattress.)  On the face of it, their reasoning seemed plausible—after all, you could live some years on $36,000 when a family of four budgeted for annual expenses of about $7,300.

As we all know, that fictional couple made a bad decision, since inflation began destroying their cash as surely as if they had burned a few bills each year.  The nest egg they “didn’t lose” could barely have bought them a car 40 years later, let alone contribute meaningfully to a comfortable retirement.  With the benefit of a Wayback Machine and 20:20 hindsight, it’s easy to see the fallacy of their logic.  So why is it so much harder for some investors to project the same logic looking forward into an unknown future than looking backward into a known past?  Maybe it’s the “unknown” part that convinces some people the future will look very different, but the reality is that unless your nest egg is invested to earn more than the long-term rate of inflation, it will be shrinking in real terms.  Inflation has averaged 4.74% per year since 1967—meaning that an annualized return less than that is effectively a negative return.  In contrast, while the stock market undeniably experienced many volatile periods during the 40 years between 1967 and 2007, $36,000 invested in the S&P 500 in 1967—with dividends reinvested—would’ve grown by more than 871% after inflation by 2007.  It turns out that short-term volatility is only scary during the short term, and it’s not the “risk” long-term investors should worry about.