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Don’t discount the impact of luck on your portfolio

Reprinted courtesy of MarketWatch.com.

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You can control a lot of variables when you invest money, but one thing is totally outside your control: what happens in the market when you happen to be invested. You can’t predict that, either.

I recently gave a speech to a group of 350 investors in Bellevue, Washington, focused on the habits and attitudes of successful investors. Most successful investors I know have developed realistic expectations for returns. They also have developed a realistic understanding of the level of risk they are taking.

In addition, they know that they have no way to predict what will happen next in the market. The very best investors have made peace with the idea that a big part of their long-term returns will depend on the unpredictability — good or bad luck, if you will — of exactly the years in which they are invested.

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Along these lines, I’ve noticed an interesting difference between successful investors and those who are frustrated and unsuccessful.

Relatively few successful investors try to manipulate or second-guess the “luck factor” by timing the market. They know that they can’t know the timing or direction of the market’s “next big move.” Unsuccessful, frustrated investors, on the other hand, very often have a strong sense of where the market is heading. They are quite confident that they can somehow know this. Most of the time, they are wrong.

The very best investors pay careful attention to managing their diversification, managing their level of risk and managing their expectations. And they don’t forget that they are still subject to luck.

This luck can be as simple as the year that you start investing or the year you retire.

People who retired in 1975, for example, probably didn’t have a good feeling about their investments. The S&P 500 Index had just suffered a 42% cumulative loss in 1973 and 1974. But as it turned out, 1975 was a very good year to start investing or to retire.

People who did that may now be wealthy and even held in high esteem for their investing savvy. In fact, a good part of their success may have come simply from being in the right place at the right time. They might look smart, but they could not have known this in advance.

Below you will find a table showing the compound rates of return of the S&P 500 Index over a variety of time periods ranging in length from three to 25 years. These time periods were not chosen randomly; they start and end at the turning points of long-term returns.

You may be surprised to find that the three-year period from 1926 through 1928 had by far the highest of these returns. However, investors who retired with great confidence in 1929 were supremely unlucky, as the next decade was to be very unproductive.

Or think about 1940 for a moment. Who could have known, during the initial rumblings of an unprecedentedly nasty world war, that the next 20 years would be extremely good ones in the U.S. stock market?

And yet, from 1960 through 1974, the stock market couldn’t even match the performance of government-insured bank savings accounts. Then 1975, as noted above, ushered in a quarter century of excellent returns. In the last five years of this period, the market rose at the astonishing rate of 28%.

And as we entered the early months of 2000, the incredible bull market of the 1990s was dashed on the shores of a nasty bear market that almost nobody saw coming. It’s interesting that the 2000-2015 return was almost identical to that of the 15-year period from 1960 through 1974.

In every case, it’s very easy to explain what happened — after the fact. But none of these big market swings was widely predicted.

This is the power of pure luck.

Time Span S&P 500 annualized return (%)
1926-1928
30.1
1929-1939 -0.8
1940-1959 14.1
1960-1974 4.3
1975-1999 17.2
2000-2015 4.1

Luck is a huge factor in our long-term success. The elephant in the room, you might say.

There’s a lesson here. I think it’s to control what you can, save more than you think you’ll need, keep your spending and your expectations reasonable – and make peace with the fact that bad luck – or good luck – may always be right around the corner.

Luck also applies to the advice you’ll find in investment newsletters. For Mark Hulbert’s view of luck in the newsletter industry, join me for a podcast on Mark’s lessons from 36 years of newsletter performance.

Richard Buck contributed to this article.