I was having dinner the other night with my friend Ray Link – a very smart guy that understands numbers. Ray mentioned he had just completed an analysis of investing in the stock market over the past decade compared to taking the safe route of parking your cash in a money market. After looking at the data, I asked Ray to be my first “guest blog”, as his numbers are pretty compelling. Now to put things in perspective, I am an ardent believer in dollar cost averaging and taking the long approach to investing. If you have the proper time horizon, asset allocation, and discipline, I would always advocate that the market can provide the best return. But Ray’s analysis clearly shows the market risk at shorter time horizons – even though many might not consider ten years a short term investment. Here are Ray’s conclusions in his own words.
Ray’s Analysis of The S&P versus a Money Market Account
The other day I was taken aback when I read that the compound return for the S&P 500 for the last ten years was a paltry 2.8%. After all, isn’t inflation running at that rate or greater? We are not talking about the return of the tech-laced NASDAQ which is still well below its bubble high, but the S&P 500 which is the barometer of the entire stock market, constituting about 60% of the total value of all American listed stock. This is big stuff. It made me wonder how that translates for the average Joe who started contributing to a 401(K) back in 1998. Surely “dollar-cost-averaging”, which is investing on a regular basis regardless of market conditions, would yield significant positive results overshadowing the peaks and valleys of the market. Using the following simple assumptions I crunched some data to see for myself:
· Assume a person invests $250 each quarter starting June 30, 1998 in both the Vanguard S&P 500 fund and Vanguard Prime Money Market fund. Both funds are well known no-load, low-fee funds. Thus, a total of $10,000 was invested in each fund over the 10-year period.
· The returns are computed net of fees with dividends and interest re-invested.
To my amazement the total value would be equal to only $11,733 if invested in the S&P 500 index fund. What is more amazing is if invested in the Prime Money Market fund it would value $11,916 or $183 more than the stock fund! In fact, if that same person invested the entire $10,000 on June 30, 1998 in both funds, the money market fund would make $1,089 more. The person who invested in the money market fund not only has more money but probably slept a lot better as that fund had positive returns in 40 of 40 quarters compared to the S&P fund which posted positive returns in just 24 of 40 quarters or only 60% of the time. Indeed these past 10 years have been very disappointing for the average investor and well below the often projected returns of 12% to 15%.
I am a big fan of the Vanguard group as they have brought low cost index fund investing to the average American so don’t view this as a criticism of Vanguard. It should also be noted that the S&P 500 over a much longer period has substantially outperformed cash, bonds, treasury bills, housing and inflation. The question is how long is long and unfortunately the past 10 years is not long enough. What should one do?
· Diversification into different assets such as international stock, bonds and money market funds.
· Continue consistent investing, especially in a 401(K) that has a company match.
· Reduce equity exposure well in advance of retirement so you have an account balance you can count on.
· Avoid misleading data such as “total returns” in marketing material. For example the Vanguard S&P 500 touts a 10 year total return of 31.9% which sounds great. Except it is a compound return of only 2.8% and lost money 40% of the time over the past 10 years and is in fact nearly 11% points lower than their money market fund. Remember if you lose 50% in one period you need to earn 100% in subsequent periods to break even.
Volatility and consistency may be far more important to you than yielding the maximum possible return, especially us aging baby boomers as we get ever closer to retirement. So look at the returns year by year to determine how the fund has performed and ask yourself if you can tolerate the rocky road which may lie ahead.
About the Author: Ray Link is a CPA and holds an MBA from Wharton. He is EVP/CFO of FEI Company (NASDAQ: FEIC), a world leader in tools for nanotechnology including the Titan, the world’s most powerful electron microscope. He is on the Portland State University Business Advisory Council and on the Board of Directors and Audit Committee for Cascade Microtech (NASDAQ: CSCD).