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Here is a graph of the S&P 500 price since 1970:
At the start of 1970, the S&P 500 was sitting at $90. By the start of 2018, it had risen to $2,683.
If you invested $1,000 every year from 1970 through 2017, you would have accumulated $532,473 (this doesn’t account for dividends).
Now, imagine the price of the S&P 500 had the exact same starting and ending prices during this time period, but had the same consistent 7.3% returns each year, with no market crashes:
In this scenario, if you invested $1,000 every year, you only would have accumulated $420,846 (this doesn’t account for dividends).
That’s a difference of $111,627.
The reason for this massive difference comes from the prices you’re buying at. In the actual return scenario, you were able to buy at lower prices during the drops, which leads to increased investment returns:
In particular, the market drops offered the best possible times to invest. These drops allowed you to invest at cheaper prices and experience significantly higher returns on investments over time compared to the hypothetical path.
To illustrate the math behind this, consider this simple example:
Scenario 1 (No Market Drop) : Suppose the S&P 500 starts at $1,000. After one year it increases to $1,100. One year later it increases to $1,200:
The money you invest in year 1 experiences a 20% (1200 – 1000 / 1000) total return by year 3.
The money you invest in year 2 experiences a 9% (1200-1100 / 1100) total return by year 3.
Scenario 2 (Market Drop) : Again, suppose the S&P 500 starts at $1,000. But this time, after one year it drops to $900. Then one year later it increases to $1,200:
The money you invest in year 1 experiences a 20% (1200 – 1000 / 1000) total return by year 3. (same as before)
But in this scenario, the money you invest in year 2 experiences a 33% (1200-900 / 900) total return by year 3. (compared to a 9% return in previous scenario)
The money you invest in year 2 has an incredible 33% total return, which crushes the return in the previous scenario. The market drop here is an opportunity for an investor to buy the S&P 500 at a cheaper price. As long as the price recovers over time, this investor will have higher returns than the investor in the previous scenario.
Why This is Important
For investors with long time horizons, market drops should be welcomed. The whole idea is that you want to invest your money at cheap prices that will appreciate over time. If the market only went up in a consistent fashion each year, you would be buying at higher and higher prices. Conversely, when the market drops, it offers a chance for you to buy at cheaper prices and experience higher returns over time once the market recovers.
For investors who dollar-cost average over time, they’ll experience much higher returns on their investments if they’re able to invest during market drops.
In particular, young investors should be hoping for a drop since they have the longest investment time horizons. In the short term it represents a loss, but over the course of decades it leads to higher returns.
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