It's official the market has hit a new high - we investors should be happy and we are. The good news is that we have now received 100% of our stock market value back since the last high, but the bad new is we have also lost 100% of the time. So congratulations you've just lost 28% of your potential output.
Time is as important as return
I live in Detroit, so I assume everyone knows that one horsepower is 550 ft/lbs of torque per second. You knew that - right? Torque is the umph in an engine and seconds are, of course, the time it puts out the power. It is a measure of the work that gets done - the result. So if there is no time-then there is no output.
Well, your portfolio value is also a measure of work - it is yield multiplied over time. Let's just say the market goes up 7% per year, that's a force - 7%, over time - one year. It is a lot like horsepower. To get horsepower you need both torque and time, and with your investments you need both yield and time.
How much work will get done?
To keep things simple. Let's say you are a 30-year old who has been given 10,000 dollars to retire on at age 65 and the market increases 7% per year. Running the numbers, 35 years later you can look forward to almost 107,000 dollars at your retirement, at age 65. Congratulations.
But let's say for the last five years the market has been flat - like now. The stock market is currently about where it was in 2008. Except you are five years older and your stocks are worth roughly the same as five years prior, $10,000.
So, let's get back on our growth track. Your investment will still compound at 7%, like before, but unfortunately you have only 30 years left to compound it. You have gotten back your money, but you have lost time. Now when I run the calculation I end up with a little over 76,000 dollars instead of 106,000 dollars - a loss of about 28 %.
When this happens you have essentially shut down your engine for five years and in the process lost a little over 28 % of your total output. That's a horsepower loss of almost a third. It's the same as if you would retire at 60 years of age instead of 65 years.
(To put things into perspective, if you had a crystal ball and had bought a five-year treasury bill you would have received about 4.5% and your 10,000 would have been worth over $12,000 without any risk - over 20 % more. But, everyone knows you can't make any money in bonds, right?)
Time is money
The point is, if you are compounding it doesn't matter where you lose your time. If you lose it at the beginning or at the end the result is the same. Time is time. The parabolic graph just shifts to the right five years. This is why age-based portfolios based on the idea that if you're young you have more time to catch up on your earlier bad investments are at best misleading.
Don't turn off your engine
No matter what your age, you need some sort of investment engine that doesn't lose horsepower for years at a time. Remember, stock market investors in 1932 didn't get their money back for 20 years.
Prudent investors should put a significant amount of their portfolio in investments that generate torque. These are investments that pay up-front in the form of steady cash-flow through good and bad markets. They need this not to make current income but to keep from losing output over time.
To put some torque into your portfolio, look for investments that generate steady cash-flow, like government guaranteed mortgage bonds - or GNMA, VMBS, MBB if you use ETFs. If you are more aggressive you could considers some mortgage REITS, Also listed preferred stocks or if it's more convenient ETFs like PFF, PGX, PFXF, PSK. Corporate Bonds, it's best to use actual bonds or exchange-traded debt but you could use an ETF like BSCJ, LQD, VCLT, QLTA. Individual high-dividend stocks or an ETF like SDY, VMBS, DEM, VYM, VIG, SCHD. and Government Bonds or ETFs like TLT, VGLT, or AGZ.
I discuss how to put these into an easy to manage portfolio here.
Additional disclosure: Disclaimer: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.