A popular idea that has been touted by influencers on social media and even Warren Buffett is to buy and hold the S&P 500. This idea is even more compelling with the rise of cheap passive investing instruments like the SPDR S&P 500 ETF Trust (SPY). The net expense ratio of this ETF is only 0.09%. It is difficult to argue against this idea when you look at the performance of SPY since its launch in 1993.
Despite experiencing significant crises since its launch in 1993, SPY has delivered a Compound Annual Growth Rate (CAGR) of 10.33%. Its annualized volatility using monthly returns is 15.13%, giving a decent Sharpe ratio of 0.68 for a simple buy-and-hold strategy. However, this is looking backward at the entire SPY history of 30 years. We usually look at a shorter period depending on our current age for retirement planning. For example, if we are currently in our 30s, we may consider retiring in 20 years. For those of us who are older, say in our 40s to 50s, we may use a shorter planning horizon of 10 years.
Let's pretend we are doing a retirement planning exercise and see if SPY can reliably help us achieve our retirement goal. Let's start with a 10-year planning horizon first.
I Want To Retire In 10 Years
For simplicity, let's assume that we require a retirement nest egg of $1 million at the time of retirement to fund our retirement lifestyle. Let's further assume that the contributions towards building this retirement nest egg can generate an annualized return of 10%. This is also the long-term CAGR of SPY. We can use any retirement calculator to determine the monthly savings required to be set aside and invested. These monthly contributions should accumulate, and grow to $1 million in 10 years.
We now have all the necessary parameters to perform our retirement simulation using SPY as the underlying investment for our savings. The simulation is straightforward. We assume that we invest our monthly contributions into SPY at the beginning of each month, for 10 years. The simulation will show how much we have accumulated at the end of the 10 years. The first simulation started in March 1993, when the SPY was launched. The second simulation began in April 1993, and so on. The result is shown below.
There is quite a wide variation of outcomes when we use SPY to build our retirement nest egg over 10 years. In the worst case, if we started our retirement journey just before the tech bubble burst, we would end up with less than what we have contributed. In other words, we lost money. In the best case, if we started after 2002, we stand a good chance of accumulating more than our target. This wide dispersion of outcomes is due to the variation in the rolling 10-year CAGR of SPY.
I Want To Retire In 20 Years
Let's now use a longer planning horizon of 20 years. Again, we want a retirement nest egg of $1 million in 20 years. The investment return is also 10% per annum. Since we have more time to grow our investments the required monthly contribution is lower.
The good news is that there is no outcome where you end up with less than you contributed. However, there is still a good chance that you can miss your retirement target. Using a longer planning horizon gives you more certainty because the range of 20-year CAGR is narrower as shown below.
Even though using a 20-year planning horizon suggests more reliable outcomes, this assumes that nothing happens in between and we can reliably stick to the plan without any deviation.
Emotions Still A Potential Pitfall
We have already established that we can experience losses after 10 years of faithful dollar-cost-averaging into SPY. 10 years is not a short period. You can't blame anyone for giving up after 10 years of wasted effort. Therefore, we may not stick to the plan to benefit from the latter half of the 20 years. Furthermore, it is not a given that a 20-year period will always be good. This is evident if we can stretch SPY back to the Great Depression in the 1930s.
Another potential danger is that SPY can experience a major drawdown of more than 40% just before the retirement deadline. This would greatly reduce the retirement amount we thought we could have. This is called sequence risk where the worst returns happen towards the end of our accumulation phase when most of our contributions are already in.
Conclusion
Having a plan is better than no plan. Therefore, I agree that a simple disciplined regular investment plan into SPY is better than randomly taking risks. However, there is still a meaningful chance of not meeting our retirement objectives using this simple approach. On the other hand, a well-diversified portfolio that dynamically adjusts to changing market environments still offers a better chance of hitting our retirement targets.
You can read our past articles https://www.allquant.co/post/why-multi-strategy-is-the-ultimate-free-lunch & https://www.allquant.co/post/why-low-portfolio-volatility-offers-better-investing-outcome to find out why.
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