The timing of bull
markets and your retirement
I have taken a lot of time off from my blogs to write a
series of essays on debt management and retirement planning. These essays should be available by the end
of this year.
This post on how the timing of a bull market could impact
the balance of a 401(k) plan was motivated by one of my essays.
Question One: A person has $200,000 in her 401(k)
plan. She contributes $500 per month to
her plan. She is planning to retire in 15 years.
What is the balance in her 401(k) plan at the end of 15
years if the annual return for the plan is 7 percent per year for 90 months
followed by 4.0 percent per year for 90 months?
What is the balance in her 401(k) plan at the end of 15
years if returns are 4.0 percent per year for 90 months followed by 7.0 percent
per year for 90 months?
Methodology: The final balance in the 401(k) plan can be
calculated with the future value function.
It is a fivestep procedure.
·
Step One: Take the future value of the initial $200,000
to the end of the first period.
·
Step Two: Take the future value of all first period
contributions to the end of the first period.
·
Step
Three: Find funds available at end
of first period (This is the sum of steps one and two.) Take the future value of these funds to the
end of the second period.
·
Step Four: Take future value of all second period
contributions.
·
Step Five: Add the results of steps three and four to
get the future value of the 401(k) plan.
It is important to use monthly returns and monthly holding
periods. It is also important to input
contributions and initial balances as negative numbers so you obtain a positive
future value balance.
Results: The future value calculation for the two
market scenarios is presented in the table below.
The timing of the bull
market


Inputs


401(k) balance at
beginning of 15 year period

$200,000

$200,000

Monthly Contribution to
401(k)

$500.00

$500.00

Annual Return First
Period

0.07

0.04

Annual Return Second
Period

0.04

0.07

Length of First Period
in Months

90

90

Length of Second Period
in Months

90

90

Analysis


FV of initial sum in
401(k) at end of first period

$337,576

$148,089

FV of monthly 401(k)
contributions to end of first period

$58,961

$38,933

FV of funds at end of
first period funds to
end of second period

$293,615

$315,672

FV of second period
contributions

$38,933

$58,961

FV all funds after 15
years

$332,548

$374,633

Observations about
results:
·
The return in the overall market is R=(1.07/12)^{90
}x (10.04/12)^{90 }for both scenarios.
·
Even though market returns in the two scenarios
are identical the final 401(k) balance is larger when the bull market occurs at
the end of the period rather than the beginning of the period.
·
The difference in portfolio outcomes is non
trivial. The difference is around
$42,000 or around 12 percent of the average of the two portfolio outcomes.
Analysis and
Discussion: The timing of the bull
market matters for 401(k) contributors because more money is exposed to the
market at the end of the holding period than at the beginning of the holding
period.
Interestingly, timing or returns does not matter when the
investment is a lump sum. The timing of
returns does not alter the future value of the initial $200,000 investment.
Financial analysts argue that people need to invest in their
401(k) plan and place funds in equities at the beginning of a career because in
the long term stocks out perform other asset classes. However, the longterm performance of stocks
will not protect investors from substantial losses when a bull market occurs
near the end of a career.
Many financial analysts argue that endofcareer financial
risk can be mitigated by investing in life cycle funds, which increase
allocation of assets towards fixedincome assets as the investor ages. The life cycle approach will lead to low
returns if the market does poorly at the beginning of the holding period and
rebounds near the end.
Many financial analysts argue that people nearing the end of
their career should make extra contributions to their 401(k) plan even if this
results in them keeping a mortgage during retirement. One of my essays suggests the safer bet is
to pay off the mortgage prior to retirement.
My essays should be available in a few months.
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