And why you shouldn’t care
IN THE LATE 1970s the view in the publishing world was that an author should never produce more than one book a year. The thinking was that publishing more than one book a year would dilute the brand name of the author.
This was a bit of a problem for Stephen King, who was writing books at a rate of two per year. Instead of slowing down, King decided to publish his additional works under the pen name of Richard Bachman.
Over the next few years, every book King published sold millions, while Richard Bachman remained relatively unknown. King was a legend. Bachman a nobody.
However, this all changed when a bookstore clerk in Washington, D.C. named Steve Brown noticed the similarity of writing styles between King and Bachman. After being confronted with the evidence, King confessed and agreed to an interview with Brown a few weeks later.
Frans Johnson’s book, The Click Moment: Seizing Opportunity in an Unpredictable World, tells the story of what happened next:
“In 1986, once the secret was out, King re-released all of Bachman’s published works under his real name and they skyrocketed up bestseller lists. The first run of Thinner had sold 28,000 copies — the most of any Bachman book and above average for an author. The moment it became known that Richard Bachman was Stephen King, however, the Bachman books took off with sales quickly reaching 3 million copies.”
This phenomenon isn’t exclusive to Stephen King either. J.K. Rowling published a book called The Cuckoo’s Calling under the pen name Robert Galbraith only to be outed by someone performing advanced text analytics.89
Shortly after the public discovered Galbraith was Rowling, The Cuckoo’s Calling increased in sales by over 150,000%, shooting to the #3 on Amazon’s bestseller list after previously being ranked 4,709th.90
Both King and Rowling’s foray into undercover writing reveals a harsh truth about the role of luck in success. While King and Rowling’s achievements aren’t solely the result of chance, it’s hard to explain how they sold millions while Bachman and Galbraith didn’t, despite being of similar quality. Luck plays an important role.
Unfortunately, the same mysterious forces that can make or break your career can also have an outsized impact on your investment results as well.
How Your Birth Year Affects Your Investment Returns
You might think that something as random as the year you are born would have little impact on your ability to build wealth, but you’d be wrong. If you were to look throughout history, you’d see that equity markets tend to go through fits and starts that aren’t easy to predict.
To illustrate this, consider the S&P 500’s annualized return by decade since 1910 (including dividends and adjusted for inflation).
As you can see, depending on which decade you were investing in, you could have received annual returns of positive 16.6% or negative 3.1% over a 10-year timeframe. This is an annualized return spread of 20 percentage points that has nothing to do with your investment choices.
However, this is just the tip of the investment iceberg. Because if you look over 20-year periods, the variance in annualized returns is still large.
Over 20 years, depending on which period you were investing in, you could have received 13.0% annual returns at best, or 1.9% annual returns at worst.
Due to this variation in returns over time, even investors with legitimate skill can still underperform those who just got lucky.
For example, if you had beaten the market by 5% each year from 1960–1980, you would have made less money than if you had underperformed the market by 5% each year from 1980–2000. This is true since the annualized real total return from 1960–1980 was 1.9%, while it was 13% from 1980–2000 (and 1.9% + 5% < 13% − 5%).
Think about that. Someone who was an incredible investor (who beat the market by 5% annually) would have made less money than a terrible investor (who underperformed by 5% annually) simply because of when they started investing. This example is cherry-picked, but demonstrates how skilled investors (outperformers) can lose to unskilled investors (underperformers) simply because they were invested during a difficult market environment.
The only good news here is that, over 30-year periods, the differences in annualized returns are far less pronounced.
Though we are only looking at four non-overlapping periods of data, it suggests that long-term investors in U.S. equities are typically rewarded for their efforts. Though this may not hold in the future, based on the record of history, I think it will.
Now that we have examined how luck can impact your total investment return over time, we also need to consider the order of your investment returns and why they matter.
Why the Order of Your Returns Matters
Suppose you put $10,000 into an investment account that experienced the following returns over the next four years:
· +25% in year 1
· +10% in year 2
· −10% in year 3
· −25% in year 4
Would you have been better off if you had gotten the returns in a different order? For example, imagine you got the same returns as above but in reverse order:
· −25% in year 1
· −10% in year 2
· +10% in year 3
· +25% in year 4
Will that affect the final portfolio value of your initial $10,000 investment?
The answer is no.
When making a single investment, without adding or subtracting additional funds, the order of your returns does not matter. If you don’t believe me, spend a minute trying to prove how 3 × 2 × 1 is not equal to 1 × 2 × 3.
But what if you add (or subtract) money over time? Does the return order matter then?
Yes. When you are adding money over time you are placing more emphasis on your future returns since you have more money at stake at a later period in time. As a result, the importance of your future returns increases as you add more money. This means that, after adding funds, a negative return will cost you more in absolute dollar terms than if that negative return had occurred before you added those funds.
And since most individual investors add assets over time, the ordering of investment returns matters more than almost any other financial risk you will face. This is formally known as sequence of return risk and can be explained with the following thought experiment.
Imagine saving $5,000 a year for 20 years under two different scenarios:
1. Negative Returns Early: You receive −10% returns for 10 years followed by +10% returns for 10 years.
2. Negative Returns Late: You receive +10% returns for 10 years followed by −10% returns for 10 years.
Both scenarios have the same returns and the same total contributions of $100,000 over a 20-year period. The only difference is the timing of the returns relative to the invested funds.
Let’s see in the next chart how you would end up by looking at the final value of your portfolio under each scenario. Note that I included a vertical line at the 10-year mark to highlight when the return sequence flips from −10% to +10% (and vice versa).
As you can see, though you invested $5,000 each year, your final portfolio value differs significantly based on the order of your returns. The Negative Returns Early scenario ends with over $100,000 more than the Negative Returns Late scenario, even though both invested the same amount of money over time.
Getting the negative returns later in life (when you have the most money in play) leaves you far worse off than if you experienced those negative returns when you first started investing. In other words, the end is everything.
The End is Everything
Given that you (like most investors) will be accumulating assets for most of your life, this means that your most important investment returns will occur as you approach and enter retirement. If you were to experience large negative returns during this time, your nest egg could be reduced significantly, and you may not live long enough to see it recover.
What makes this scenario even worse is that you could be subtracting money during retirement, which would deplete your nest egg at an even faster rate.
Fortunately, the research suggests that a bad year or two in the markets isn’t likely to have a significant impact on your retirement. As financial expert Michael Kitces discovered, “In fact, a deeper look at the data reveals that there is remarkably little relationship between returns in the first year or two of retirement, and the safe withdrawal rate that can be sustained in the portfolio… even if retirement starts out with a market crash.”91
But what Kitces did find was that the first decade of returns (specifically inflation-adjusted returns) can have a significant impact. While one or two bad years is no big deal, a bad decade can cause serious financial harm. This illustrates why the investment returns during your first decade of retirement are so important.
Given this information, below is the decade when your investment returns will matter most based on your year of birth (assuming you retire at 65):
· Born 1960 => 2025–2035
· Born 1970 => 2035–2045
· Born 1980 => 2045–2055
· Born 1990 => 2055–2065
· Born 2000 => 2065–2075
Since I was born in 1989, this implies that I need my best returns from 2055–2065 (when I should have the most money invested). But even if I don’t get the stellar returns that I desire, I know that there are ways to lessen the impact of luck on my finances.
How to Mitigate Bad Luck as an Investor
Despite the importance of luck in investing, your financial future is more in your control than you might realize. This is because no matter what markets do, you always get to decide how much you save/invest, which assets you invest in, and how often you invest. Investing isn’t just about the cards that you are dealt in life, but how you play your hand.
As much as I respect the importance of luck in both investing and in life, I am not powerless to it. You shouldn’t be either. There is almost always something you can do to counteract bad luck both before and after it occurs.
For example, if you are on the verge of retirement and you are worried about a bad decade for markets, here are a few ways in which you can limit your downside:
· Adequately diversify with enough low-risk assets (e.g., bonds). Having a large bond portion as you enter retirement may be able to provide enough income to prevent you from selling equities at depressed prices.
· Consider withdrawing less money during market downturns. If you had originally planned on withdrawing 4% a year, temporarily lowering your withdrawal rate could help mitigate the damage done by a market crash.
· Consider working part-time to supplement your income. One of the benefits of retirement is that you get to decide what you want to do with your time. This means you could start working on something new to generate income instead of selling down your existing assets.
Even if you aren’t on the verge of retirement, using proper diversification and making temporary changes to your income/spending can be incredibly helpful during difficult financial times.
And if you are a younger investor, the best way to mitigate bad luck is time itself. Since most markets go up most of the time, as we saw in chapter 13, this means that time is a young investor’s friend.
Regardless of your financial situation, you will always have options to combat bouts of bad luck. More importantly, bad luck isn’t always as bad as it seems. Sometimes it’s just a part of the game. This is why the subject of our next chapter is market volatility and why you have no reason to fear it.
89 Zax, David, “How Did Computers Uncover J.K. Rowling’s Pseudonym?” Smithsonian Institution, Smithsonian.com (March 1, 2014)
90 Hern, Alex, “Sales of ‘The Cuckoo’s Calling’ surge by 150,000% after JK Rowling revealed as author,” New Statesman (July 14, 2013).
91 Kitces, Michael, “Understanding Sequence of Return Risk & Safe Withdrawal Rates,” Kitces.com (October 1, 2014).