Most millennials freaked out in early February when the stock market went into a tailspin. In fact, they should not only have been cheering, they should have been hoping for a major bear market.
That’s because the value of their portfolio will be much higher when they retire if there’s a big drop sooner rather than later.
Millennials certainly don’t view it that way, however. The oldest of that generation—someone who was born in 1981—was just 26 when the last severe bear market began. Chances are good that he or she was still paying off college debt at that time and was not even invested in equities. That means that many — if not most — millennials today are entering the phase of their lives in which they save and invest heavily in their retirement but have no experience of living through a bear market.
To illustrate why millennials should be hoping for a bear market, I calculated the impact on their retirement wealth of when bear markets occur between now and then. I focused on a hypothetical millennial who was born in 1981 and who will retire in 2048 when he’s 67 years old. To make the simulation easier, I made a number of assumptions that, while unrealistic, don’t bias my conclusion one way or the other: I assumed that he currently has $100,000 in his 401(k) that is fully invested in the stock market and that he invests the maximum amount each year in that portfolio (along with an employer match).
I also assumed that the stock market gains 10% annually except for three years in which it loses 25%. A three-year bear market of 25% annualized losses approximates what the stock market lost during the financial crisis between 2007-2009.
The results are shown in the accompanying chart. Notice that this millennial’s portfolio value in 2048 will be highest if those three years of 25% annual losses occur immediately. It is lowest if those three bear-market years occur right before he retires. Notice also that the difference is huge—between $4.3 and $1.9 million (in 2048 dollars).
My simulation is an example of what economists refer to as path dependency. In all cases plotted in the accompanying chart, the stock market’s average annualized return between now and 2048 is the same — 5.9%. The only difference is the order of gains and losses along the way.
One way in which millennials can wrap their minds around this is to ask themselves how likely it is we will have at least one severe bear market in the next 30 years? As soon as they allow that it’s totally unrealistic to expect the stock market to go three decades without a bear market, then they can focus on the timing of a major decline rather than whether or not one can be avoided altogether.
In any case, it’s worth emphasizing that a world without a bear market would actually produce lower retirement wealth than one in which there is an earlier bear market. Consider what the impact would be of a steady 5.9% return in each and every year for the next 30 years. In that event, believe it or not, my hypothetical millennial’s retirement wealth in 2048 would be lower ($2.4 million) than if there was an immediate bear market ($4.3 million).
This $1.9 million difference should be big enough to convince millennials to stop fantasizing about permanently avoiding a bear market.
If these results seem counterintuitive, think of it this way: To the extent there is an early bear market, all new money that our hypothetical millennial invests in the stock market will be buying in at lower levels, and those yearly investments will have that much longer to compound out their gains.
By the way, the situation facing an investor about to retire is just the opposite of our hypothetical millennial. At retirement, an investor’s portfolio is likely to be at or close to its maximum value, and he will no longer be investing new monies each year in that portfolio. That’s when a bear market will have maximum destructive impact, just as we saw for the millennial if a bear market were to occur over the three years immediately prior to retirement.
For this reason, some retirement experts are now recommending that retirees’ increase their equity exposure during retirement rather than reduce it. I devoted a Retirement Weekly column to their argument last September, so won’t repeat it here. But the underlying logic is the same.
The bottom line: Millennials should be careful what they wish for. Even if we somehow could avoid a bear market for the next 30 years, their retirement wealth would likely be substantially better if we instead experienced an immediate bear market.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.