3 min read
Yesterday I shared an interactive chart that lets you visualize potential future S&P 500 returns.
It’s a simple chart, but it’s useful for understanding how different potential price paths could impact investment returns.
The blue line represents the price of the S&P 500 from 2018 to 2038. You can drag each circle up or down in each year to see how different price paths affect investment returns during this 20 year time period.
NOTE: The chart doesn’t account for dividends. It also assumes you follow a dollar-cost averaging strategy and invest the same amount each year in the S&P 500.
The Path to Investment Returns Matters
The following three scenarios illustrate why the path of investment returns matters. In all three, the S&P 500 has the same starting and ending prices, but drastically different paths.
Scenario 1: The Steady Increase
Suppose the price of the S&P 500 steadily increases each year over the next 20 years, from $2,700 at the start of 2018 to about $5,500 by 2038. If you were to invest the same amount of money each year, your average compounded annual returns would be 2%.
Scenario 2: The Crash and Recovery
Instead, suppose the price increases to $3,000 by until 2020, only to experience a massive 50% drop to $1,500 by 2022, followed by a steady recovery to about $5,500 by 2038. In this scenario, if you invested the same amount each year, your investments would earn 4.30% average compounded annual returns.
That’s a pretty incredible difference compared to the previous scenario. In this case, a market crash within the next few years would allow investors to buy S&P 500 shares at much cheaper prices in the short-term, which would lead to higher investment returns over the long-term.
Scenario 3: The Boom and Crash
Another possible scenario could be that the S&P 500 increases steadily over the next 10 years, only to crash sharply and recover to $5,500 by 2038. In this case, investors who dollar-cost average each year would experience 2.23% average compounded annual returns.
The Big Picture
The numbers in the previous three scenarios are completely made up, but they illustrate an important point: the path to investment returns matter.
For young investors with long investment horizons, an immediate market drop would actually be the scenario that leads to the highest long-term investment returns, assuming these investors could stick to a dollar-cost averaging strategy during a market crash and keep buying while others are selling.
Conversely, the worst-case scenario for young investors would be if the market keeps rallying for several more years, only to crash a decade from now. In this case, investors would be buying S&P 500 shares at higher and higher prices, which would hurt their returns when a market crash finally does occur.
Give it a Try
Play around with the interactive chart yourself to see how different price paths could impact future investment returns. I only covered three potential scenarios here, but there are many different paths the S&P 500 could take over the next 20 years.
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Zach is the author behind Four Pillar Freedom, a blog that teaches you how to build wealth and gain freedom in life.
Zach's favorite free financial tool he's been using since 2015 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.
Although the bulk of his net worth is invested in index funds, his favorite place to invest in individual stocks is M1 Finance, a site that allows you to build a custom portfolio of stocks for free.
His favorite way to save money each month on his recurring bills is by using Trim, a free financial app that negotiates lower cable, internet, and phone bills with any provider on your behalf.
His favorite micro-investing app is Acorns, a free financial app that takes just 5 minutes to set up and allows you to invest your spare change in a diversified portfolio.
His favorite place to find new personal finance articles to read is Collecting Wisdom, a site that collects the best personal finance articles floating around the web on a daily basis.
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