We hear again and again that buying and holding stocks for the long term is a great investment strategy. Yes, stocks can have their ups and downs, we are told, but in the “long term”, they are a great investment.
Long-term stock returns. Is this really true? Whenever someone makes claims about returns, always ask them to see the actual numbers that they are referring to. To evaluate the claims about stocks, lets consider the annual returns from 1998 to 2008. Why are we starting in 1998? Simply because that’s the first year for which data on all three TSP stock funds is available. From 1998 to 2008 is 11 years. Since people typically work and save for their retirements for about 30 years, performance over 11 years is a good indicator of how useful a strategy might be for one’s long-term retirement savings.
So, how well have the stock funds performed during this time? The C Fund, which invests in large-cap stocks and tracks the famous S&P 500 stock index, has had a compound annual return of 1.00%. That is correct — one percent. That’s not a typo. An annual return of just one percent every single year for a total of 12% over the 11 years. The other two stock funds have performed slightly better, returning 2.34% and 2.46% annually. Of course, one would have had a much better return by simply putting all of one’s money in the G Fund, the money market, which has returned 5.00% per year.
Returns with dollar cost averaging. But these numbers, though they are so miserable, still do not reflect the true extent of the problem. You see, this return of 1% per year assumes a lump sum investment. In other words, you would have gotten the 1% per year if you had invested in the C Fund at the beginning of 1998 and made no further deposits to or withdrawals from your account.
But that’s not how people save for their retirements. When people save for retirement, they typically put a little bit of money into their retirement plan throughout the years. This is called dollar cost averaging (DCA). Some people like to pretend that DCA somehow magically turns bad returns into good ones. Again, when you hear these claims, ask the people who are making them to see the numbers. The reality is simply that DCA returns are different from lump sum returns. They could be higher or lower – it depends. There is no one-to-one correspondence between the two types of returns.
When we account for dollar cost averaging, over the past 11 years, the C Fund has actually lost a total of 15%! Again, these are not the “short-term” ups and downs. This is a real long-term loss. For example, suppose that since 1998, a TSP participant had contributed $10,000 per year into the C Fund. This means that they contributed a total of $110,000 into the fund. However, by the end of 2008, they would have had only about $93,000 in the fund. That’s a real long-term loss of $17,000 over the 11 years.
Unfortunately, TSP only reports gains and losses on a lump sum basis. Because of this, many TSP participants do not even realize that they have lost money. Or, if they suspect that they have lost money, do not realize how much money they have lost.
If not stocks, then what? Many people feel that stocks are their only option. If not stocks, where else would you invest? Money market and bond funds are safer, but they do not generate high enough returns. What else is an investor to do?
We have a solution that is conceptually very simple. We pick the mix of TSP funds that maximizes the expected returns while not exceeding a fixed maximum risk. This means that instead of staying in a fund, we shift in and out of it based on its performance. There is nothing wrong with stocks per se. There are times when stock funds perform very well. And during those times, we are holding stocks. But when stocks are performing poorly, we get out of them. That’s our simple secret to outperforming every single TSP fund over the long-term.
Consider the numbers. During the same 11 years that the C Fund returned 1% annually, our Conservative allocation returned 6.59%, while our Balanced allocation returned 9.98%, almost ten times as much as the stock fund!
When we account for dollar cost averaging, the difference is even more stark. Over the 11 years from 1998 to 2008, on a dollar cost averaging basis, our Conservative allocation returned 41% while our Balanced allocation returned 71%. Consider the same example of a TSP participant who contributed $10,000 per year for 11 years, for a total contribution of $110,000. If this participant had followed our Balanced allocation, they would have made $78,000. By the end of 2008, they would have had $188,000 in their TSP account.
