The Power of 100% Stock Market Investing: Mitigating Income Sequencing Risk Over 40 Years

Investing in the stock market can be daunting, especially with the looming risk of market downturns just as you approach retirement. However, an investment strategy over a 40-year horizon (a typical working life) that focuses entirely on the stock market can effectively mitigate income sequencing risk, often outperforming the traditional 60/40 portfolio of stocks and bonds. Here’s why a 100% stock market portfolio may be your best bet for long-term financial security.

Understanding Income Sequencing Risk

Income sequencing risk refers to the danger of experiencing a market downturn just as you begin to withdraw from your retirement savings. This can be particularly damaging if your portfolio suffers significant losses early in retirement, potentially depleting your funds more rapidly than anticipated.

The Historical Performance of Stock Market Investments

Over the past 200 years, the stock market, specifically using the US as a reference point, has shown impressive resilience and growth. A traditional 60/40 portfolio, comprising 60% stocks (part owning 100's if not 1000's of the most well-funded and innovative businesses in the world and 40% bonds (lending to these great businesses and governments), has yielded an average return of 7.3% per annum. While respectable, this figure pales compared to the roughly 10% per annum return achieved by a 100% stock market (owning buisnesses) portfolio.

The Compounding Advantage

The difference in annual returns between these two strategies may seem modest at first glance, but over a 40-year period, the power of compounding significantly magnifies the disparity. For example, investing ￡200 per month over 40 years at the historical 60/40 portfolio 7.3% average annualised return would amass to around ￡535,099. At a 10% return 100% stock market portfolio, this investment would grow to around ￡1,110,907. The substantial increase underscores the power of a higher average annual return.

However, if you were able to increase your contribution annually by 3% to combat inflation and maintain your money's purchasing power, the effect is even more dramatic. The same ￡200 per month investment, with a 3% annual increase, would grow to ￡777,968 at 7.3% and an astounding ￡1,505,938 at 10%. The total amount invested over 40 years at a fixed ￡200 per month would be ￡96,000, and with a 3% annual increase, it would be ￡180,969. The growth is extraordinary.

But Wait, It Gets Even Better

The best way to save for your retirement in the UK is to invest your funds into a personal pension. The great thing about pensions is that the government incentivises you to save for your retirement by offering attractive tax breaks. If you are a basic rate taxpayer, they will increase every contribution you make by adding 20% tax relief. For example, if you contribute ￡200 per month, the government adds and grosses up 20% on top 200/.8 = ￡250, increasing it to ￡250 per month.

Let's revisit these figures assuming you invest your net ￡200 per month (￡250 gross with tax relief) into your personal pension and see how these figures look by using the same 2 portfolios; the traditional 60/40 portfolio and the 100% global stock market index tracking portfolio. An index-tracking fund is a type of investment that aims to mirror the performance of a specific market index, like the FTSE 100 or S&P 500. Instead of picking individual stocks, it buys all or a representative sample of the stocks in these indices, making it a simple and low-cost way to invest in the broader global stock market. There are many indices that cover the global stock market. This can equate to investing in literally thousands of companies globally.

Option 1: The Traditional 60/40 Stock Market/Bond Investment

A. No increase in monthly pension contribution over 40 years:

- ￡250 per month, with 20% tax relief added, growing at the historic rate of a 60/40 stock market/bond portfolio using the historical annualised average return of 7.3%, would grow to ￡714,164.

B. Increasing monthly pension contribution by 3% per annum:

- Starting at ￡250 per month and increasing it by 3% per annum, your fund would grow to ￡1,030,866.

Option 2: 100% Globally Diversified Low-Cost Index Tracking Funds

A. No increase in monthly pension contribution over 40 years:

- ￡250 per month, growing at the historical return of 10% per annum, would grow to ￡1,581,019.

B. Increasing monthly pension contribution by 3% per annum:

- Starting at ￡250 per month and increasing it by 3% per annum, your fund would grow to an eye-watering ￡2,120,778 using the long term historical returns as an example.

These figures are based on long-term past performance and are significantly aided by the power of compound interest. Compound interest is interest paid on accumulated interest, continually growing your investment much like a snowball gathering more and more snow as it rolls down a hill.

Investing in your pension through globally diversified index-tracking funds not only takes advantage of tax relief but also leverages the growth potential of the stock market, providing a robust strategy for building a substantial retirement fund.

Weathering Market Downturns

One of the critical advantages of a 100% stock market portfolio over the long term is its ability to recover from downturns. Historical data suggests that even with periodic market corrections and crashes, the stock market generally trends upwards over extended periods. By remaining invested in the stock market, investors are likely to experience significant growth that can offset short-term losses.

The main trade-off of investing in the stock market as opposed to bonds is that you must be able to deal with more volatility. This is also known as the risk reward premium. The underlying investment does not change; it's the global stock market, period, but the percentage of your money you allocate to it determines how much volatility you must accept. Historically the more you have in the stock market the greater the volatility but the better the long-term returns and with bonds, generally lower volatility but lower returns. Volatility should be embraced because this is how you get the long-term growth.

Mitigating Risks Through Time

The fear of a market downturn just as you retire is valid and scary. However, a 100% stock market portfolio’s expected higher returns over 40 years mean that even if a downturn occurs, the accumulated wealth typically far exceeds what a 60/40 portfolio would achieve. Thus, the potential impact of income sequencing risk is lessened because the larger nest egg provides a more substantial buffer against market volatility.

Why 100% Stock Market Investing Works For The Long Term Investor

1. Higher Long-Term Returns: As demonstrated, a 100% stock market portfolio offers higher returns over extended periods compared to a 60/40 portfolio.

2. Compounding Growth: The effect of compounding significantly amplifies the benefits of higher returns, resulting in substantially greater wealth accumulation.

3. Recovery from Downturns: Over 40 years, the stock market’s tendency to rebound from downturns helps mitigate the risks associated with income sequencing.

Conclusion

While traditional investment strategies like the 60/40 portfolio have their merits, a 100% stock market approach over a 40-year investment horizon presents a compelling case. The substantial historical returns and the power of compounding make it a formidable strategy to mitigate income sequencing risk for the long term investor, ensuring that even if markets dip as you near retirement, you’re likely to have a significantly larger financial cushion. Embracing a long-term, stock-centric investment strategy can be a prudent move for those seeking robust retirement savings.

It's important to note that these figures do not include the costs of investing. Therefore, keeping these costs as low as possible is crucial. To achieve this, ideally, you should invest in globally diversified index-tracking funds. Even after accounting for investment costs, the figures remain very substantial on a pro-rata basis.

Always work with a trusted advisor who understands your goals and aspirations. While past performance cannot be guaranteed, the historic growth rates, based on 200 years of data returns, provide a long-term overview of investment returns. Everyone has a different attitude to risk and varying tolerance for volatility, but these numbers are difficult to ignore for the patient, plan-based, goal-focused investor with a good investment temperament.

Investing in the stock market over the long term means that your investments will most certainly fall in value from time to time. This has always been the case, but don't forget that when this happens, your ￡250 is buying the stock market at knock down sale prices meaning you are getting more bang for buck, and everybody loves a sale. Over 200 years the stock market has thus far proven one undeniable truth; the falls are temporary, but the advances are permanent.

Finally, another great aspect of pensions is the automatic discipline it has built in. You can't access your pension until you reach the age you are allowed to access them. This stops you from meddling and interrupting the compounding effect. Currently for people approaching retirement, this is age 55, but could soon go to age 57. During a 40-year savings period legislation is bound to change, but this should not detract from the astounding numbers given time.

Robin Powell Mark T Hebner Manning and Company

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