Is your Crystal Ball too Optimistic?

crystal ball investingI was 25 years old when I first started seriously thinking about investing in the future. I had graduated from college with a Mechanical Engineering degree a couple of years prior and was beginning my career at my current company.

The year was 2002, and although the dot-com bubble was still fresh on everyone’s mind, it had no impact whatsoever on my investment philosophy at that time, since I was still too early in my career to be an active participant.

The only impact that period had on me was a delayed start date at my first career of choice (consulting), and subsequent near lay-off, which landed me at my current company in the energy industry.

Perhaps one of the reasons the dot-com period didn’t leave as big an impression was the level of technology at that time. The information didn’t feel as “in your face” at it does today. Let’s take a short walk down memory lane…

Available Technology in 2002

I can’t believe this is going to make me sound old to some, but “back in 2002”, the news didn’t travel as fast, and general awareness was foggy at best.

phone 2002Phones:  You might remember the Nokia 6600, it was the most popular phone that year. Today my iPhone is light years more powerful than my original work computer and keeps me informed, whether I like it or not.

Internet:  Less than 10% of the world population was on the internet, compared to close to 50% today.

Websites:  There were approximately 3 Million websites in 2002, compared to over 1 Billion today.

Speed:  56K Modems were still the thing back then, now I run 300 Mbps. Can you imagine the level of patience people had back then?

PF Blogs:  I don’t even know if any existed, I’m sure there were a handful of hobbyists at the time. Now there are thousands full of valuable knowledge.

My point is, information was still traveling down country roads and hadn’t yet merged unto the super-highways of today. This meant that personal finance knowledge and wisdom was relatively limited.

My State of Mind – 2002

Imagine a young Max, with a new job, an ambitious drive, and a risk-taking attitude. Here I am in my wilder days…

2001 yamaha r1

I had nothing to lose, and everything to gain. This was the best time for taking risks.

One thing I had picked up on despite the previously mentioned technology handicaps was that the key to retiring was investing.

Armed with that one nugget of wisdom, I decided to invest in my company’s 401k program as soon as I turned 25, with the intent of maxing it out as quickly as I could afford to (which took me about five years).

Since I was goal-oriented, I set out to build a handy excel spreadsheet to keep track of my net worth and other financial details.

I wanted to project out what my investments would look like over the next 30-40 years. At that time, I was planning on working until the age of 55 and had no concept of freedom years. I did what many people do, and used the historical return of the S&P500 over the past 100 years for my projections.

Here’s a snapshot of how the index performed during that period. The calculated Compound Annual Growth Rate (CAGR) for the period was 9.98%** (including dividends & without inflation).

Check out this convenient calculator from MoneyChimp.

What a great run!

S&P500 Index 100 Year

Although those returns look impressive, to my 25-year-old self, they seemed ordinary. Who wants to settle for “ordinary”?!

** Notice that I’m not using/quoting the average return of 11.84%, which is what most financial analysts use when describing historical rates of returns for any index. The CAGR is the accurate representation of performance, while the average return is financial trickery.

My Desired Growth – 2002

Surely I can do better than “ordinary” returns; I just needed to be a bit more aggressive. At the time, I settled on what seemed to be a reasonable 12% return per year. We had just experienced the dot-com crash, and things could only go up from here, right?!

I gave my crystal ball a good rub and popped the growth rate into my brand new excel spreadsheet. I then sat back in amazement while it did its compounding interest magic. Here’s a snapshot of my crude table from that period, along with salary and contribution estimates.

I used an assumption of 2% for inflation against my salary, and 401K max contribution increases.

401k projection

According to my projections, I would have over $5,000,000 in retirement funds by the time I turned 55!

And ten years later, I would have close to $15,000,000!!

My expectations were locked in, and my entire plan now revolved around those projections. But something didn’t feel quite right, so I remained cautious about spending, and kept increasing my savings rate.

The Reality of 2002-2017

The S&P 500 Index in 2002 stood at 1,140 on Jan. 1st of that year.

Based on my expected CAGR of 12%, it should be sitting around 6,240 today. Even if I used the more “conservative” historical CAGR of 9.98%, the S&P 500 Index should stand at approximately 4,750.

Since I now have the benefit of hindsight for the past 15 years, I can gut check my 25-year-old Max assumptions against reality.

Despite what seems like a roaring market recently, the actual CAGR from 2002-2017 was only 6.65% as shown in the chart below, and the index stood at just 2,275 on Jan. 1st 2017.

S&P 500 Index 15 Year

That’s a rate of return almost 50% less than my initial projections! Using those actual returns, I would end up with “only” $2,000,000 by the age of 55 compared to the $5M initially projected.

And this includes the period between 2009-2017 which ran at a CAGR of 14.49%, which begs the question…

What if I was 25 Years Old in 2009?

Running through these numbers and my personal history made me wonder what my state of mind could be if I were a 25 year old in 2009, or perhaps even today.

Could my crystal ball be too optimistic? If I looked at the historical CAGR (9.98%) and the past eight years (14.49%), I might be tempted to project a rate of 12% by splitting the difference.

Of course, I can’t predict the future, and this isn’t a post about market timing. But any sound financial strategy includes some projection of the future. All we have is history to guide us, but it’s up to us to determine how we apply the lessons of the past, and how optimistic or cautious we are.

Here’s just one example of past returns. Timing is everything with life, and the same applies to invest. As much as we talk about 100-year historical returns, most of us only really care about that 40-year period we plan on growing our wealth.

To that end, I tried to model a fictitious investor who begins investing at 25 years old and stops at 40 at the age of 65. I wanted to see how big the spread was on returns during different periods. Here’s the summary of my results.

years invested

I’ve also included more recent years and performance so far for comparison. As you recall, the rate during my investing period so far has been 6.65%.

The spread for the 40-year periods is 7.71%-12.14%. That’s a reasonably significant difference when you pop your numbers into a compounding calculator.

Hope is not a Strategy

In my current role, we do a lot of planning and forecasting. I like to remind people during those sessions that hope is not a strategy. I believe in planning for the worst, and hoping for the best.

Sure, I might still get that 12% CAGR that my 25-year old self dreamed about, but should that be my strategy?  As I’ve grown older, and hopefully wiser (not by much), I’ve become more cautious with return projections. I also no longer ride crazy fast motorcycles!

I’m comfortable planning around the actual return of my investment period at 6.65%, or maybe even lower. Investment returns, at least relative to the stock market, are not within my control. What I can control are my income and my spending. Managed right, the resultant cash flow can feed my FIRE fund, and I can build in more buffer.

My advice to 25-year old Max is not to count on a high rate of return as the sole strategy to wealth. Build in a more conservative return in your projections, force yourself to hustle for additional income, cut back expenses as a hedge, and diversify your investments.

Readers, do you use a CAGR or Average Return when predicting the future? What type of projections do you use? Is your financial independence strategy heavily dependent on strong returns? Share your thoughts and comments below!

Max

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