New Investors Should Hope for a Terrible Stock Market

0:00Just quickly before we get into the episode, at the minute we're really trying to understand how people in the UK are saving for their futures. We hope that we can turn it into something really useful, maybe a rapport or a video on my channel. We'd love your input, it would take about five minutes, it's completely anonymous and if you're up for it you can find a link in the description. What is the ideal stock market for a new investor? Most people think the answer is simple, you want the line just to go up. But what happens if you start investing just before a crash? Andrew Clare has spent years researching everything around savings and retirement.

0:34We've got him on to chat about a recent paper, which might just change the way you look at stock market crashes. There'll be periods where people will have to work longer, periods where people retire earlier. Simply just because of market performance throughout their life. Because that's exactly what you're taking a risk on throughout that 40-year sort of accumulation journey. We're going to talk about the paper, understandably, but I hear you write novels as well. I do. So I published a novel a couple of years ago called The Old Lady, and it's based loosely on my time at the Bank of England I spent there but within the book there's more blackmail, kidnap and murder than there was at the Bank of England so I need to make that very clear.

1:11I went to the Bank of England recently and there's a fair bit of blackmail and murder it gives those vibes. Yeah yeah it does. But no let's let's speak about the paper I got on to.

1:20Andrew Clare:I had a question um in the paper you talk about the perfect contribution rate and the perfect withdrawal rate uh what's the simplest way to explain that to our audience before you answer. Yes, because I do not understand too much in detail. Well, first of all, contribution rate is the amount you contribute to a pension pot, and withdrawal is the amount you withdraw when you come to retire. So somewhere in the world, there is a perfect amount that you can contribute. And our paper takes data from 150 years or so of data and tries to work out what would have been the perfect contribution rate at various times in history to see how it evolved over time as well.

2:01Then we also look at the withdrawal amount. So we assume you retire after 40 years or so, and then we're working out the perfect withdrawal rate. Now, that is a bit trickier because the withdrawal rate, the money you withdraw for your pension has got to last you a lifetime. Most people don't know how long they're going to live. And that's one of the big dilemmas in terms of pensions, which is why we have annuities, which you can get onto later. But what we do is say, well, supposing you have a target at the age of 85 to have all this particular part of money spent, how much would be the perfect amount to withdraw over that period of time?

2:40Now, in reality, you're never going to get perfect contribution or perfect withdrawal. So the key message of the paper, key messages of the paper, is one, to have a target. okay you need to know where you want to get to and you know how much money you want by that time and then you need to work out at that point how much you think you need to contribute to then the second thing is to say that you need to review that on an annual basis you know you cannot make that decision at 25 and expect to do nothing and change nothing over the next 40 years or so. So at each point, you're kind of iterating towards your retirement and checking whether you're on target or not.

3:26And it's in that way that you can gradually edge towards your target. Okay, so that's one of the key messages of the paper. The second key message, which is really about this thing people refer to as mean reversion in equities. Now, what that means is that essentially is over long periods of time equities will go down but they'll generally come up and generally speaking they will outperform most other traditional asset classes so if you were to pick an asset class that you wanted to invest in for a long term most people would advise equities okay problem with equities is they are volatile but if you've got a 30 or 40 year rising you should be able to see through that.

4:15So why does mean reversion work? Because it may not work in the future. Why has it always worked in the past? Mean reversion in equities works because equities are a claim on the economy, on growth in the economy. Essentially, that's what you're buying when you buy an equity, buy something different with a bond. So essentially, what your bet is, is that the global economy is going to continue to grow over time. And generally, that has happened okay if it doesn't happen and you've made the wrong bet i 100 equities and growth doesn't come through and so on you probably got more to worry about than your pension pot at that point seriously you probably should be thinking about buying bottled water cans of beans and a shotgun because without economic growth of the kind that we've seen over the last 200 years or so we're in a lot of trouble so it's kind of a no-brainer particularly for people in their 20s 30s 40s even 50s to be investing their pension majority of that in equities and taking account of and taking the benefit of this mean reversion over time yeah we're going to get into lots of that because the mean reversion can be it can be counterintuitive about where you how your investment life cycle should look and these things but you said something a second ago about shotguns and water and and you basically said if we don't see growth like we've seen in the last 200 years but we're a lot older than 200 years and and it's kind of like we're we're taking a slither wouldn't even be a second on the kind of the the clock of the human species let alone the earth and you're basically saying as long as we keep doing what we've done for just this fraction of a moment we'll be okay is that is that silly thing to think oh it's an excellent point most We've grown up thinking about growth.

6:06Governments talk about growth all the time. Liz Truss was obsessed with it. Don't go any further there. The current government's obsessed with it and so on. And growth essentially is what pays for the public services and all the good things we need in our lives. The interesting thing is that economies like the UK, the US, and so on didn't really experience this year after year after year of growth until we got the Industrial Revolution. So you're dead right. It's just a flicker in time in terms of man's history. But we're living in a sort of capitalist economy post-Industrial Revolution. And that era is an era of an economic growth.

6:49And that's what we would assume and hope is going to continue. And if it does, equities will continue to outperform most other masterclasses. I know there was a period where Japanese steelmakers would just engrave their prices on the wall for generations. So their dad would have engraved their prices on the wall because nothing changed. Yeah, I mean, that's inflation. And actually, inflation is a fairly modern phenomenon too. Really, up until the turn of the last century, persistent inflation, in other words, getting prices right every year, 2 % or 3 % or 4 % or 5%, that's a fairly new thing too.

7:24And that's come as part of the economic growth that we get. It's difficult to explain why they go together, but that is a modern phenomenon as well. Is that a way to force growth? Yeah, I guess some economists would argue that 2 % inflation is really good. It sort of oils the wheels of industry and commerce and so on. It's difficult to prove that, but it also does make some kind of sense that a little bit of inflation is probably good for economic growth and the economy. I think that's the most convincing reason I can think of to invest in equities. You want to capture that slice of growth. What you actually want to do is outrun the persistent force of inflation that's targeted.

8:06It's a force that governments want to happen. And if you just sit still, you'll just get eaten alive by it, right? And equities, you're buying into a slice of the businesses that are increasing their prices. You're buying into the inflation on the other side of it. You're buying into economic growth. which is denominated in nominal terms, in cash terms. So, yes. Okay, well, a bit of a tangent there, but I think when someone says, well, we're just going to hope everything keeps growing, I'd like to know why, because it's not the norm, right? Yes. Pre-Industrial Revolution, it's not the norm, but post it definitely is.

8:43Yeah, yeah. Fingers crossed. Yeah. So what did you find in between the relationship between perfect contribution and perfect withdrawal? Or if we call them P, perfect, PC and PW, you call them PCR and PWR. So, yes, that's just the rate. An interesting finding was something which you, and it does go back to mean reversion as well in terms of equity prices, but what we found was if you were experiencing a period of low returns in equities and you're contributing, then therefore your contributions are not getting the boost that you wanted them to get. So you have to put in more, okay? okay um so in that world you're putting in more contributions but it turns out because of mean reversion in the post retirement period in the withdrawal period the returns are catching up so actually you're able to withdraw more when you retire having put in that sounds odd but it's not just because you put in more you put in more just to keep you know keep running on the same spot once you get to that spot you can actually withdraw more because the returns tend to be higher in a period post a period of low returns you call it the justice of the system almost yes that wasn't my my phrase but it was a co-office phrase but yes it's kind of uh you're getting payback if you like for your hard work in the run-up but it works the other way if you've got a period with very high returns when you're contributing so you're not having to run so fast to get anywhere the other side of that you're getting low returns so you might actually end up being able to withdraw less that feels like now so someone who's contributed say from the financial crisis and built their retirement pot over the last roughly 20 years they've experienced the longest ball run in america's history and the american dominance of you know the market basically they might now be looking at a period of potentially lower returns than they had over the last 20 years and they might that might hurt them they might be but then of course they're looking at a higher starting pension pot as a result of that so that that's the sort of balance on the other side but yes that's that's true so what did the perfect contribution rate measure exactly then you know so we have we we hypothesized uh an amount that our uh pretend person would have wanted and we just because you need to do a like-for-like comparison over time so they were trying to hit the same target over time yeah you have a great chart that shows the impact of different periods throughout time where basically it's like you know if you're born on this day or you start on this day this is how much you'll need to contribute and you looked at like the the great depression and things and you effectively show i think it's this one figure one is it's title 40 year perfect contribution rate and it just shows the different contribution rates required to hit a target going all the way back to 1872 and the interesting thing about this chart is you've got to go 40 years into the future so you're contributing in say um like a bad period to retire might be 2008 right so you're going 40 years back from that and going well if you're contributing here we know that 2008 is coming to your contribution rate needs to be higher so that when you hit there yeah you have enough and that's why it's perfect in that regard because we know because you have 2020 hindsight so there's a period here around 1880 where the contribution rate is the highest and you've got it as a percentage so it's 1.5 percent at that point if you see here yeah what does that mean 1.5 per year of um your i can't remember how we actually defined it but it's of your salary yes 1.5 of your earnings a year yeah but then in other periods so you've got this period of say 1910 it's about 1912 it drops right down to like 0.2 percent yeah what's going on there because there you're you're you're experiencing after that a really significant period of equity market rally, I suppose.

12:37So the average, I think, came out about 0.5, I think, in the end. So what we were trying to say, there's no correct number that you can take away from that, say this is how it's going to be in the future. Well, that shows just how variable it is, which is scary. Until you go back to the mean reversion idea, you say, well, okay, you've contributed quite a lot then, because you needed to, and you got to the same point. but the good news is because the mean reversion the withdrawal amounts you can take are commensurately higher um so that's the good news from that and of course as we talked about earlier it works the other way too what's the ideal kind of market then for an investor over their lifetime would it be a pretty bad one when they're accumulating and a really good one when yeah pretty much buy cheap and sell high is um and the good news good kind of good news is over a 40-year period you're going to have quite a lot of periods where things are going to be cheaper and you just keep investing in those periods and don't sort of get scared to help things have fallen by 20 therefore i'm no longer to contribute because my pension part's gone down by 20 it's you know none of it's worth it and i think those are the times and it's difficult but those are the times when you really should keep going and possibly even increase.

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15:32If proving your compliance is something that you need to get done, you can get started at vanta.com forward slash making money. There's a link in the description and we've also put a QR code on screen. If you're accumulating then or you're trying to build a pension pot in a period of bad returns, how should you be thinking about that then? Because on one hand you're saying you're paying in more because you're not getting the returns, but at the end you might get better returns. So could you say, well, I don't need to pay in more then. I can just pay in a lower amount today because I'm going to get the good returns down the line.

16:02You could take that risk. But I think at the end, what you really need to be doing is at each point in time, making sure you're doing enough to make sure you hit that target that you need to get to as close as possible yes it may not be possible um it may be that the contribution rate required is too high but as long as you're doing something and the key message for anyone with regard to pensions is start early start early and pay low fees that would be my advice to anyone what if you can't start early um start as early as you can yeah i mean it's as simple as that really and understand that even if you're 50, you've got a bank and you're 40, 50 years ahead of you anyway.

16:42So it's like going back to a 10-year-old and going, it's too late for you to impact your life by 50. So just on a personal note, I didn't really start doing any pension saving until my early 30s. Because most people have mortgages and kids and things like that. And nowadays, generations have got

17:00Andrew Clare:student debts to pay off and so on. Instead of mortgages, we've got student debts. Yeah, exactly. Three good years, mate. Yeah. great years and then pay for it for 10 yeah um but yeah i mean um you do what you can and most people i think realistically start saving seriously for the pension once they get into their 40s unless they're lucky enough to be in a good workplace pension where you know which we which are now sort of less common nowadays um the age of 40 plus is when people really start saving for pension very inspiring for me yeah yeah let's i want to talk about that meme reversion because it's kind of like oh the if the market's bad now it should be good in the future why does why does that happen because the global economy is still growing essentially so ultimately um what you're getting i suppose in the poor times is what you can refer to as a higher risk premium you're paying a high risk premium so in other words usually it's because people think the risks in the world have are elevated so in other words to encourage me to buy equities you've got to promise me i've got to buy them at lower price really because the world's risky so it's like anything really and and generally those risks dissipate after a while depends what what they are what we're going through at the moment looks terrible and is terrible it will pass at some point and companies will go back to profitability and so on and it goes back partly to the business cycle and this is something that does annoy a lot of economists lots of very clever economists actually and that is explaining why a business cycle occurs in the first place why can't we just have stable growth but it just seemed to be that the capitalist economies grow in this kind of boom bust cycle not necessarily bust not necessarily boom but sort of good and bad times over time if we could explain why um we might get closer to you know leveling off that um business cycle and to some extent over the last 20 years the business cycles have been a little less extreme than they were in the 60s and 70s um for better management of fiscal policy and monetary policy over the last 20 or 30 years.

19:18But so in other words, equities will go into cycles and they're really kind of reflecting, I suppose, the cycles that the underlying economy are going through too. And the waves of human emotion. It could be, yeah. Emotion definitely plays a part. Like rational exuberance around the tech and then the pessimism and you're kind of that cycle. Exactly, exactly. And that affects, that doesn't just affect equity prices, it can affect businesses too. Because if you're a businessman, you own a business, And you're very pessimistic about the future. You're not going to open up that new factory or you're not going to take on those new people until your business confidence returns.

19:55I mean, I think Keynes called it animal spirits. So even back in the 30s, someone like John Maynard, Keynes, a very famous economist, was talking about the behavioral aspects, which are often really important in explaining economic phenomenon. I think someone once said to me, the stock market is you're riding an escalator with a yo-yo in your hand and you're looking at the yo-yo when you should be looking at the escalator. And your escalator is the global stock market, the global growth, basically, story. It is. And I would say, generally speaking, checking your investments regularly when you're saving over a long period of time is probably not a good idea.

20:35And unfortunately, technology, so I can open up my iPad now and find out exactly how much my investments are worth and the temptation is to keep looking. There are some studies out there which show that people who sort of look at their investment portfolios far less frequently tend to do a little bit better than those that are kind of constantly looking and fiddling around with them. Yes, the fidelity dead people one.

20:59Andrew Clare:Yeah, but you said earlier that for your perfect contribution, you should be looking at it annually. But like you said, we've had lots of people saying, like, invest in a global index, leave it, don't tamper if it goes down either invest more just keep dollar cost average and leave it until you're ready to retire or start yeah so where's the balance so certainly a review of your financial position every year it's not like i did what i didn't i didn't mean that you don't never look at it in 40 years time so an annual review of where you are to work out how far down the path towards your target you've got is a really good idea um and some people can do that with financial advisors and other people who can do it on their own.

21:40And actually, artificial intelligence and chat GPT-ing things can actually get you a long way with giving you the sort of information you need. So review it and take a judgment. Because it's not just the markets that's going to be changing each year. It might be you. You might have just had a baby, just got a mortgage or whatever so i think you need to review it even if the world hasn't changed because you might have how long how long are these reversion like how long does that is that process really that's quite difficult to say um but what i will say is the the ups and downs these cycles in the equity right seem to be getting slightly shorter so the downs don't last so long the ups don't last so long um but really um you we could be entering a prolonged down phase for what i know or prolonged up i don't know but we're talking probably three to five years something like that i would say um okay so in the paper you looked at the s &p 500 in particular probably because the data set is the most fleshed out right do you think your conclusions would have been different if you looked at say a global portfolio um it's very difficult to say without having done it but i would say that the results there would be fairly typical of most of the developed equity markets so uk equity market would probably have given you very similar results in terms of that relationship between contribution and withdrawal um but that's difficult to prove so you can only do as much as you can with the data but no i mean uk equity market us equity market some of the other major developed markets tend to move together over time.

23:29So you would expect the results to be relatively similar.

23:33Andrew Clare:But if you're looking at emerging markets, it would be completely different. Yeah, I mean, emerging markets would just, you know, over a long period of time, have a higher average return, because of where they are, might be slightly more volatile, but you would still expect mean reversion in those markets as well over long periods of time. Do you think your research should really change how we emotionally look at bear markets like you said buy low sell high but human nature is to do the opposite relish them in accumulation yeah we should be like yes hopefully downturn for next three years please so i can just stack but people don't think like that yeah no i mean i'm very understand so the market goes down by 10 for example and someone comes on to one of those youtube podcasts actually it's a good time to buy and they might be right and the next day they go the market goes down by another 10 yeah so um calling the bottom of the market is quite difficult and you know what it's easy to see with hindsight when you should have bought it's very difficult to see at the time once you you're in it so the thing to do is just to keep buying and not panicking across this timeline there's been lots of people that have now retired I wonder if, you know, have you seen or do you see like cohorts where you're like, oh, this group here are having a really tough time in retirement because they've been accumulating through this phase or not.

24:53Have you taken any of this into the real world? Well, the problem with that is that this real world hasn't been around for that long. So up until, let's say, end of the 1990s, most significant pension accumulation was done in defined benefit pension schemes, where all the risk is taken by the employer, the sponsor. So you know if you've done 30 years in that company, you're going to get 30 80th of your final salary. You don't have to care about whether the market's going up or down. The company does. And that was the problem. When the high-tech bubble occurred in 2001, equity markets fell dramatically.

25:38And so me, with my 30 years of service, I don't care. The company still has to pay me 30 80th. But the company's now trying to pay you 30 80th out of an asset pot which has just fallen by 30%. which is why a lot of defined benefit schemes started to close around that time, forcing people into defined contribution schemes. So we're only really now starting to see a world where a significant proportion of the population are retiring only with a defined contribution pot. Even now, most people my age will probably have some DP in their history, financial history, and some DC. Your generation are going to be 100 % DC.

26:25That's why this is important, because you're going to be managing that. Your employer, if you have one, is not going to be taking that risk. You are. And that's the big change over the last 20 years, that we've moved from that world of DB and state provision as well to a world where, you know, which has probably existed for some time in the us but in a world in the uk where we're going to be managing our own pension pots making our own decisions yeah i imagine like to make my own point again if we extend out 100 years into the future and if we keep a flat contribution rate of eight percent like we do at the minute we'll get these cohorts where it's like oh their retirements are pretty crap because they just happen to be at the wrong point along this line and they would you know they might have got a good market while accumulating a bad end so you'll get you know generational poverty within pensions just dependent on market side you will but of course if they've had the bad returns in leader they should be able to get more in the end if the mean version is right um and also they will then combine that retirement with part-time working and and so on um the last part of the paper was trying to limit the extent of sequence risk in other words the returns that's the cash and the equity investment in a trend following context we were just trying to show how that there were was potential to reduce that risk but yes it's going to happen there'll be periods where people will have to work longer and people periods where people retire earlier simply just because of market performance throughout their life because that's exactly what you're taking a risk on throughout that 40 year sort of accumulation journey and especially if you're not asking am I doing enough?

28:07You know, if you're just relying on the 8 % default, you're basically saying there is a perfect contribution rate and it's 8 % for everyone all the time. And that might not be the case. It might not be the case. And that's where you need to review your situation. It may be exactly what you need. It may be more than you need, but it might not be. And that's why you need to sort of review these things annually, if not every couple of years.

28:31Andrew Clare:In the paper, you say equities and cash are the only two crucial asset classes to consider? Why only those two? Okay, I can't remember saying that, but I'll have a go. I think, first of all, there is a growing consensus

28:48that diversifying from equities, corporate bonds, high-heeled bonds, and a bit of property and so on, which sounds like a good idea. But over the long term, if you're going to get equities outperforming everything and this mean reversion, there is thinking that in that accumulation period in particular actually equities are as good as anything now you do need to worry about the value of that equity pot as you come to retire i think we're going to talk about that a bit but um yeah so equities the bit about cash is the last part of the paper where we're trying to deal with something called sequence risk which is you know the returns turning up in the wrong order.

29:33A really simple example is you've got your million pound pension part, you're just about to retire, it's all invested in equities, and the equity market falls by 30%. So that would be an extreme example. Whereas if that 30 % happened 20 years before, you have plenty of time to make it up, so on. So it's the order of returns that really matters. And there's a table in our paper that shows that. What we were doing with the cash and equities was proposing experimenting with a very common investment rule which people use called trend following where you are either in equities or you're in cash and you tend to move into cash when the equity market is declining and you're in equities when the equity market is rising and so what that tends to do is preserve capital so if you can avoid the big downturns because you're in cash when you get back into the market you're rallying from a higher position so you get a kind of leverage effect and that's trend following that was just one example we were trying to share to use to show that you can deal over long periods of time with sequence risk that may not be the way you want to do it but that is one possibility um and so yeah we've experiment so that in that in that um sense we were using equities and cash we weren't using anything else um not bonds corporate bonds or government bonds we weren't using property and so on so there's this feeling that really over certainly over a long period of time equities are really um it's the the diversifying across asset classes is perhaps worth it's not worth the effort would you include gold in that as well and um some people would i i wouldn't i mean go yes it gold's an obvious one now because it's through the roof um and in fact we have a paper where we do basically have global equities bonds cash and gold um but yes i wouldn't buy gold now but a bit of gold when it falls back to where it was before five ten percent of your portfolio So not a bad bet.

31:44But on the other hand, it could go nowhere for 20 or 30 years. There's no mean reversion in gold prices. Yeah, it did go nowhere for 20, 30 years. Exactly. Gold is a kind of a bit of insurance, if you like, when things are really badly. Then it picks up. Bottled water, shotgun and some gold. Exactly, yes, yes. If you can afford all of those, then you're fine. So, yes, gold is more like a hedge against some really bad events, really, tail events. And so people in diversified portfolios may hold 5 % of their portfolio in that, depending where they are in their journey. Yeah. The table you mentioned is table one.

32:22Yeah. I like this table. I actually used a section of it in one of my latest videos, my YouTube channel, just because I thought it was quite a really good way of showing sequence risk or sequencing of returns risk, which is this idea that you could get the same set of returns as another person but if their returns are in the reverse order you get vastly different outcomes if you're taking from the pot yeah so if you just had for you know like a you use 40 percent 5 10 and minus 25 then you've got a table here where you iterate every version of that we'll put it on screen for the people on video but just i describe it for the audio people and yeah if you're withdrawing from a pot i did it a really simple example of saying if you've got a million pounds and you need to take 50k a year and you've got the sequence of returns the best returns would be 40 10 5 20 minus 25 and you flipped it they would go through the same journey for four years they would have a hundred thousand pound difference at the end even though the the return average return over the four-year period is the exact same exactly the same and the risk is the same they both have the same risk yeah it's essentially i think a good way of describing it is you're kicking your portfolio when it's down so in that first year when it goes minus 25 and you have to take 50k it never recovers from that position it's a dead weight loss yeah it's dead weight loss yeah it's a great table i'm not going to take any credit for that was james seaton you're not taking credit for any of this you didn't take credit for justice i thought i was going to no but james should get the credit for the table so can you explain what the the pcr and pwr bit of this table is or what what that means here um yeah so the pwr the pwr is essentially um how much you could withdraw each year as a result of, you know, let's say take a million pounds or a hundred thousand pounds or whatever, and with these set of returns.

34:15So that's what you could draw. And the PCR is the opposite. This is where what you'd need to contribute to get to a million dollars if you had this sequence of returns. So it's the reverse, really. It's probably easier to think of it in PWA withdrawal terms. It's all what's going to be left after four years if you withdraw that amount of money from a$100 ,000 pot over four years. These are sorts of like the what is the meaning of life question for pension savings, aren't they? How much should I pay in and how much can I take is the impossible question to answer in a way. It's a difficult question to answer, certainly.

34:55And the term perfect in these papers refers to the fact that because we're using historic data, we know what the answer is. um that's why i was saying that the message from this is to sort of plan and review and think about this mean reversion element of that you get in equities and so that's the forward-looking message from the paper um but yeah we've been experimenting with this sort of thing for for some time i mean the other the other thing which we kind of touched on which is not in this paper which is in other papers we have is the role that annuities can play i was about to ask you oh there you go

35:33Andrew Clare:beating me to the go on you ask your question i do we did an episode on annuities and i thought it's gonna be boring but i do love an annuity i think it's a great product dame is always like i need a newity um tea um but you mentioned like equities and cash and if the market's going down you should have cash um but if you've got that right amount for retirement let's say you've got your million that's your target whatever it is um should you then leave the risk game get out of stocks and just buy an annuity that depends very much on you if you are very risk averse if you can't possibly afford for your income to decline over time because you're in you're managing your own portfolio then an annuity may be the right thing for you maybe that it's 100 percent right for you.