The Role of Luck in Your Portfolio

In The Success Equation, Michael Mauboussin tells the story of a man in the 1970s who set out to find a lottery ticket ending with the number 48. He bought the ticket he was looking for and ended up winning the lottery using his lucky numbers. When the man was asked why he wanted that specific number on his ticket he replied, “I dreamed of the number 7 for seven straight nights. And 7 times 7 is 48.”

I guess, at times, it’s better to be lucky than good.

I was reminded of this story yesterday while I was having a discussion about the possibility for much lower than average stock and bond returns over the next decade. I said if this happens it would actually be a positive development for those who are planning on being net savers over the coming years because lower returns have typically been accompanied by increased levels of volatility. This would give investors who dollar cost average into the markets plenty of opportunities to buy at lower prices.

The counter-argument I received was that the sequence of returns can matter a great deal in these scenarios. If the final year happens to fall during a market crash or a roaring bull market, it can create drastic differences in the ending balance. After some back and forth my conclusion was that, unfortunately, sometimes luck plays a larger role in our investment performance that many are willing to admit.

For example, I took a look at all 30 year annual periods going back to 1928 using a simple 75/25 U.S. stock/bond portfolio. There have been 58 such instances in all through the end of 2014. For each I assumed that an individual decided to start out saving $5,500 per year, increasing that amount annually by 3% to account for inflation. So every period has the same exact portfolio with the same amount saved (I’m ignoring the time value of money over the different time frames because I’m more concerned with the effects from the sequence of returns than anything).

How much do the returns streams matter over time when it comes to the ending balance after 30 years? It turns out they can matter a great deal as the range in ending balances was huge and highly dependent on the time period selected to start saving money.

For example, the best scenario turned out to be someone who started out investing in 1970 and finished saving in 1999. This was the perfect 30 year period because the 1970s were a difficult, volatile decade for financial market returns, so you would have been buying up shares at lower prices, most notably during the 1973-74 bear market, at the outset. And the period ended at the peak in one of the greatest bull markets of all-time. The ending balance in this scenario was nearly $2.9 million (these numbers are gross of all fees and expenses so take them with a grain of salt).

On the other hand, the worst period started in 1945 and ended in 1974 at the bottom of that nasty bear market in the mid-1970s. The ending balanced was just $774,000 or nearly $2.1 million lower than the 1999 end date. The crazy thing about these results is that the returns weren’t that bad in the worst period. From 1970-1999, the annual returns on this 75/25 portfolio were very good — 12.5% per year. In the 1945-1974 time frame the returns were a very respectable 8.6% annually. That’s a great return over three decades, but the low end point penalized the results.

The hypothetical investor in each of these scenarios did everything they could to ensure a successful outcome, including an annual rebalance. One just happened to get lucky while the other didn’t. A few takeaways from this example and my discussion:

  • Relying exclusively on investment returns to power your portfolio is very risky. Saving more and earning more money can help reduce this risk.
  • Having a flexible long-term financial plan is key. The example provided here is fairly static and we all know that real life is much more dynamic. Nothing is ever set in stone, so any time you’re looking out over a very long time horizon you’ll be making estimates with a very low degree of precision. That’s just the way these things work. It’s best to make updates and corrections over time, as needed.
  • It’s worth remembering that your portfolio doesn’t have a start or an end date, nor does your risk tolerance stay the same throughout your lifetime. In the 30 year time horizon with the best ending balance, the end date was just before stocks got cut in half over the ensuing two and a half years. People don’t stop investing the day they retire as most have many more decades ahead of them. The results of the worst case scenario that ended in 1974 would have been dramatically improved by a few year’s worth of patience. Real life performance is never quite the same thing as you’ll see on a spreadsheet or simulation.
  • Saving money over time in the financial markets can yield exceptional results. The average ending balance for all the 30 year periods I looked at was over $1.4 million (again, no fees or distributions taken). The actual amount saved in this example was only $261,000. Compound interest is a wonderful asset that not enough people take advantage of.

Further Reading:
Things People in the Finance Industry Don’t Want You to Know
Rooting For a Bear Market?

Here’s the stuff I’ve been reading lately:

What's been said:

Discussions found on the web
  1. bwoyat commented on May 29

    Ben, this is a great article and the very concept that I’ve been explaining to my clients for years. The tool we use for creating a Retirement Income Analysis is based on this very idea. The Luck Factor! Check out
    Jim Otar is the expert in this field and he created what I think is the most advanced planning tool available. He also wrote a fantastic book called “Unveiling the Retirement Myth”. I highly recommend reading it!

    • Ben commented on May 29

      Thanks for the heads up. I hadn’t heard of this before and someone else just emailed me about it. I’ll play around with this website and see if I can track down the book.

      • bwoyat commented on May 29

        you can download the book, articles and whitepapers from his site. And the software itself is very inexpensive to download!

        • Ben commented on May 29

          Good deal. I’ll be sure to check it out.

  2. ST commented on May 29

    Even Buffett has stated his investment success is due to the luck of being born at the right time — only one person born in the 1930’s is the richest man on the planet. Then again, if we define “luck” as exposure to opportunity, one has to have the gumption to take advantage of said luck.

    • Ben commented on May 29

      Agreed. I think admitting this fact is one of the first steps to having some humility about the markets, one of the things I think is very important for those who are successful.

  3. Scott Boone commented on May 29

    As an advisor, its a bit difficult to explain to a client how important luck will be to their long term investment performance. As your article illustrates, when you invest plays an important role in long term investment outcomes. I would take issue, however, with the notion of trying to dollar cost average by taking advantage of periods of higher volatility as this smacks of market timing. Better to stick to the old adage: “save early-save often,” in which you invest new money when it is received, rather than trying to figure out the best time to invest.

    • Ben commented on May 29

      Right, what I was saying it that those DCA dollars will go a lot further during the highly volatile periods. You can’t stop investing just because volatility strikes. In fact, most of you long-term gains will come from investing during these times.

    • Richard Garand commented on May 31

      That’s right – there’s one thing more powerful than DCA, and that’s investing as much as possible as early as possible. If you have the cash available, the odds are against any “strategic” delays in getting it in the market. There is the risk of doing this at a bad time, but if like most people you earn more and invest more every month this risk is also removed.

  4. BA31 commented on May 30

    Any thoughts on how this “luck” concept applies to the current rise of the robo-advisors? Could the robo-concept be “the right idea, at the wrong time?” As you have noted in the past, the likely “returns” going forward of the basic 60/40 portfolio and by association the basic robo-portfolio is going to be paltry. There is no doubt that the robo-concept is here to stay and it will benefit a large investing populace, but the movement, overall, has overtones of hubris. The robo-movement just seems to be wrapped in a less offending package. It seems that every multi-year, bull market gives rise to a new methodology based on “it really is this easy, or we’ve got this all figured out, just simply do XYZ and you will be smarter than everybody else.” Nothing seemed more rational at the time than putting your entire retirement funds in the Magellan Fund the day before Peter Lynch announced his retirement. Let’s invert. It would go against every single investor behavior throughout history if robo account holders were going simply dollar cost average over the next decade and grind it out through the backdrop of low, low single digit returns and probably at least two major 30-50% draw downs.

    • Ben commented on May 30

      It’s a good likelihood that many of the new index investors are weak hands, but every time there’s a bear market many “long-term” investors capitulate and lose their cool.

      I actually think the robo-advisors are a positive. Especially if the alternative is high cost active MFs that are just closet index funds. It’s systematic, low-cost and remember these firms utilize a global asset allocation approach, not just US stocks and bonds. Of course, people still have to stick with them through thick and thin. See this one I wrote earlier this year on the subject:

      • BA31 commented on May 30

        Thanks for the reply Ben and for the great writing and research. I guess we will all see how it will play out!

        • Ben commented on May 30

          Thanks. This is part of what makes the financial markets so interesting. We’ll see…

  5. Simon Cunningham commented on May 31

    Did you just quote Woody Allen’s Match Point?

  6. Richard Garand commented on May 31

    It seems like the period starting in 1970 could have been even better. Higher inflation may have led to higher raises for some workers, which would allow them to increase their investments faster.

  7. Links – Week of June 1, 2015 | Signal/Noise commented on Jun 01

    […] The Idolatry of Interest Rates Part I: Chasing Will-o’-the-Wisp (GMO) podcast: Masters in Business – Dimensional Fund CEO David Booth (Bloomberg) The Risks of Owning an Individual Stock (Alpha Architect) The Tax Threat to Your Mutual Fund (WSJ) Being a Good Loser is Essential to Becoming a Good Investor (Pragmatic Capitalism) Hope Over Experience (Indexology) The Asset Allocation Within Your Asset Allocation (Marotta On Money) Low cost is just the first step in picking funds: Bogle (CNBC) paper: Facts About Factors (Cocoma, Czasonis, Kritzman and Turkington) The Risks and Rewards of Self-Managing Investment Portfolios (New York Times) When & How Active Managers Outperform (Bason Asset Management) 60/40 Portfolio Performance During Economic Cycles (Novel Investor) The Economist Who Realized How Crazy We Are (Bloomberg) The Role of Luck in Your Portfolio (A Wealth of Common Sense) […]

  8. jonathan selsick commented on Jun 02

    Glad you wrote about this Ben, thanks. One of my pet peeves is to see funds touting their performance, in a graph, over some period, and inevitably its a nice left-to-right upward sloping line and of course above whatever benchmark they are comparing themselves to. In some cases they might have “got lucky” in the first year only, and perhaps even under-performed for the balance, yet that first year’s performance will keep the performance distorted for many years. Move the start date one year forward and the performance looks terrible compared to the benchmark. I understand that in marketing a fund, you need to get the investors attention, and a nice looking graph does the job better than anything else; but it’s something investors should be aware of.

    What investors should focus on is the average annual return (as well as drawdown and sharpe ratios) for the period shown, versus the benchmark – this is a better indication of the manager/funds skill.

    • Ben commented on Jun 02

      Agreed, the numbers don’t always tell the whole story and shifting the start or end date can have a huge impact. You also never see any fund firms showing real returns after inflation either.