Raleigh NC Financial Advisor: Generational Investing
Market volatility can be intimidating. However, the general opinion is that investors should remain invested and stay true to their strategy. This will help them achieve their goals over the long term.
Investors must accept the market's returns and their unpredictable sequence. This leads to different emotional experiences among different generations when investing for the long-term. Reality must be accepted, however.
Interestingly, the effects can sometimes be paradoxical. Generations often face disappointment in the market during their early years. In response, they tend to withdraw from investing.
This is not ideal as they should be saving more. Those who experience success are positively reinforced. They are more likely to save due to the perception that their good behavior is being rewarded.
A growing body of evidence on investor behavior indicates that younger investors who began saving during the Great Recession exhibit greater skepticism towards stock markets and long-term investment. The market may improve but this challenge could remain. Just like after the Great Depression, the bull market of the 1950s and 60s did not convince all investors to return. It is crucial to consider this generational bias when designing initial portfolios and financial plans for millennial and younger clients.
Sequence of returns: Mathematics vs. behavior
First, a little mathematics. The commutative property of multiplication states that the answer of multiplying numbers together is the same. It does not matter what order the numbers are multiplied in. And the same is true when it comes to investment returns.
In other words, in investing, it doesn’t matter whether the good returns come at the beginning or the end. The final result is the same.
Figure 1: Sequence of Returns Does Not Matter With a Fixed Buy-and-Hold Portfolio
Source: Kitces.com
The commutative property of multiplication applies to investment returns. However, it is only valid when each return is weighted equally. This implies that when cash flows enter or exit the portfolio, such as ongoing contributions or withdrawals, a risk is created.
This risk is called "sequence of returns". It arises when calculating the actual dollar-weighted return in the real world.
A retiree may face poor returns in the early years while taking withdrawals. This can cause their savings to be depleted before favorable returns can help balance their losses in the long run. Researchers are now finding that millennials may become the next "Lost Generation." This is because the financial crisis occurred during their formative years, leading to slower wealth accumulation.
An individual who is still in the accumulation phase and making contributions is less impacted by a bear market. This is especially true in the initial years when the savings balance is small. However, a market decline in the last decade leading up to retirement can have a significant adverse impact.
The "retirement red zone" is a critical period. This period is the decade prior to retirement and the first 10-15 years of retirement. During this time, the portfolio size is at its largest. But it is also most susceptible to the consequences of poorly timed market declines.
In contrast, bear markets pose less of a problem in the later years of retirement. This is because there is less time left for the portfolio to grow. Similarly, a bear market at the beginning of a young saver's journey has a lesser impact since, during the initial years, the amount saved and the rate of savings have a more substantial effect than the growth on the still-modest account balance.
Figure 2: Portfolio Size Effect and Exposure to Sequence of Return Risk Over Time
Source: Kitces.com
However, the principles of mathematics governing saving and investing for retirement do not align with the psychological experience of individuals. Investing can be especially intimidating for young savers who are new to the process. A negative experience can have a long-lasting impact, leading them to develop an aversion to future investments.
The 1950s and 1960s saw impressive stock market growth after World War II. Despite this, many Americans who had grown up during the Great Depression chose not to invest in the market. They had been scarred by early losses. This could have been through media exposure, their own investments, or the experiences of family and friends.
Researchers are discovering that millennials may become the next "Lost Generation". This is due to the financial crisis that happened during their formative years, which has caused them to accumulate wealth slower. From a mathematical perspective, individuals who experience favorable market returns require less investment for retirement since their assets are growing substantially. Conversely, those who encounter poor returns need to save more to compensate for the setback.
However, the ironic reality is that those who experience early positive returns often save more, feeling rewarded for their diligent savings behavior. Individuals who experience unfavorable returns often decide not to increase their savings to make up for the losses. Instead, they may save less or give up investing altogether.
Generational paths and wealth creation
Return sequencing has a huge impact on the trajectory of savings, investing, and wealth creation. This is because the market returns, which no individual investor can control, are the biggest driver of return sequencing. Investing behavior and market timing can worsen results. However, most of the uncertainty arises from the market's volatile and unpredictable sequence of returns.
Beginning to save and invest when one enters adulthood can have a major effect on their wealth accumulation. This is due to the era in which they start.
For instance, consider the relative paths of the various current generations of investors: baby boomers (born 1946 to 1964), Gen X-ers (born 1965 to 1980), and millennials (born 1981 to 1997).
Baby boomers are transitioning to retirement, while Gen X-ers are in their peak family stages. Millennials, on the other hand, are just beginning their careers and families. All three generations started saving in early adulthood. And as it turns out, they had very different starting points.
The chart below shows the path of wealth over the first 10 years of early adulthood (from ages 22-32) for the various generations. Since most generations are 15-20 years wide, they are broken into early/late sub-groups to better separate out their relative early investing experiences.
Figure 3: Growth of $1 for First 10 Years of Adulthood for Various Generations
Source: Kitces.com
Portfolio growth for the first 10 years
The results show a distinct difference in market trends between generations during the young adult years. This divergence is significant. It is important to note that for early baby boomers in the 1970s, stock market investing was not as prevalent as a primary path towards retirement. The introduction of the IRA in 1974, with a meager contribution limit of $1,500 at that time, marked a significant development.
The 401(k) plan was not included in the Internal Revenue Code until 1978. Its implementation in corporate America did not begin until 1982. This was due to the IRS issuing regulations in 1981. Consequently, in practice, most early baby boomers commenced their retirement account savings around the same period as later baby boomers.
Hence, we observe two distinct subsets of generational investors with vastly different early investment experiences. Baby boomers and early Gen X-ers who initiated their investments in the 1980s and 1990s, respectively, had a favorable start.
In contrast, late Gen X-ers and early millennials, who began investing during the years preceding the tech crash and financial crisis, encountered a challenging first decade as investors. Late millennials have only recently started their savings journey. Consequently, it is too soon to make definite conclusions about their investment experiences.
Figure 4: How Birth Year Impacted Early Adulthood Investment Experiences
Source: Kitces.com
It is important to recognize that market volatility has a greater mathematical impact on retirement savings in the long term. This impact is more significant during the later years compared to the early years. However, the initial trajectory of saving and accumulation significantly influences the overall path that investors follow throughout their lifetime.
This effect is further magnified by the tendency of human beings to project the recent past when the future remains uncertain. Despite facing challenging market conditions in the decade preceding retirement, baby boomers already hold positive sentiments and perspectives regarding markets and investing.
They maintain a "faith" that any market disruptions will recover promptly, thanks to the positive experiences they have already encountered. On the other hand, younger generations have predominantly encountered negative experiences with investing. Therefore, even if better future returns eventually average out, their current outlook is comparatively pessimistic in relation to previous generations.
Figure 5: Differences in the Generational Experience of Saving for Retirement
Source: Kitces.com
The chart shows that early accumulators have experienced a noticeably different retirement savings journey across generations. This is when $250 is saved each month, or $3,000 each year. Baby boomers were ahead from the start and then rocketed further ahead in the second decade of accumulating. While early Gen X-ers had a good start, but faltered midway and are just barely catching up and late Gen X-ers and millennials are still struggling to even get going.
Gen X-ers were keen to invest in real estate in the 2000s. Unfortunately, they suffered the largest loss of home equity during the financial crisis. This timing phenomenon may explain why.
Millennials have been quick to invest in alternatives such as Bitcoin and other cryptocurrencies. Unfortunately, this has not had a successful outcome. This helps to explain why they have been so eager to invest in such alternatives.
Bottom Line
Our experiences in early adulthood can shape our attitudes for the rest of our lives. This is especially true for our experiences with investing. Recognizing this is key.
The biggest determinant of our early adulthood investment experiences is beyond our control - "what the market delivers". Despite this, we can still influence our investment experiences.
Sources:
https://www.horsesmouth.com/how-your-birth-year-shapes-your-investment-experience
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