Imagine a working career from age 20 to age 60 in a world of three investment options. Somehow you know with certainty all three will start at $10 per share and end up at $1000 per share after 40 years. Investment A stays around $10 for several decades and jumps to $1000 right at the end. Investment B jumps quickly to a high value approaching $1000, and then stays relatively flat for several decades. Investment C marches up a consistent percentage every year on its way to $1000. Which one would you want? Think about it for a moment before reading on.
If you want to retire at a typical age and have the most money possible, you would actually want investment A. You would have the chance to work a full career and save as many dollars as possible to benefit from that magic 100x bump near retirement. Flat periods in the stock market (and even downturns) can actually be great for investors who are still working and have a chance to accumulate investments at lower prices. The problem is that even if there is a light at the end of the tunnel, it can be hard to stay the course even if a good eventual result is likely (but not guaranteed).
Investment C would be a great choice as well. A 100x return over 40 years doesn’t require as big of an annual return as you might think- only about 12.2% each year. That doesn’t sound too impressive but really adds up over time. If you wanted to retire early or have more financial flexibility throughout life, you would probably pick investment C. You could compound your early earnings to help replace your income and then continue to make consistent returns as you move into retirement and begin to spend.
If this imaginary world is anything like ours, the irony is that nobody would care a bit about investment A or C. Everyone would love investment B! The founder would be hailed as a visionary and a hero. There would be compelling YouTube videos of smart-sounding, confident people explaining why they’re putting their life savings into investment B, even though investment B’s attractive returns are all in the past. Sure, you might turn $100 into $10,000 while living in the basement as a student at age 20, but in the grand scheme of things, that money will end up making almost no difference in your long term financial trajectory. In fact, it would reinforce the wrong lessons and likely lead to much worse choices going forward.
When it comes time to pick investments in a 401k, most people just look down the performance column and pick what has done the best in the past. By doing that, rather than focusing on the long-term drivers of market performance, you’re likely picking things that will end up a lot like Investment B. There is variation in financial markets, but confidence in your financial plan and investment strategy can help you ride out the rough times and meet your goals rather than succumbing to the siren song of past performance.