Performing a simulation for the future using returns of 7% to 8% shows a smooth graph, but how would my savings look like if I used the real past performance of the stock market?

The Wealth Manager gives a nice way to peak into the future and make informed decisions on how much to save and what my expected future lifestyle can be based on certain assumptions. However, simulations never turn out to be the exact outcome, so I was wondering how to get a better feel on the performance of my investments in the long run by doing a backtrack with the historical stock market performance. The stock market is known to move in a so-called random walk pattern, which basically means that any day, the market can go up as well as down. In the long run, the market is known to go up, but the path is not smooth and market crashes are known to happen as we experience for the moment.

My first action was to perform a simulation with the Wealth Manager, first to set the parameters that apply to me and to have a feeling of how much I should save and when I can retire. The outcome is given in the following figure

I start with $50,000 today invested in the stock market that yields me 8% per annum (this is the historical return of the S&P 500) and I plan to retire at 65 with $4,000 per month. The additional parameters are given as follows:

• Monthly contribution to my portfolio: $500
• Expected increase in monthly contribution due to salary increase: 2% per annum
• Portfolio return during retirement: 4%  (a more conservative portfolio is advised during retirement)
• Inflation to be taken into account for my retirement costs: 2% per annum

The simulation shows me that at the age of 88, I will have $450,000 left in savings, that should be enough as I do not expect to live much longer.

Now, If I do the same simulation, but with the real annual performance that the S&P 500 yielded since 1959, I have the results as shown in the figure below: I do not have any money any more at the age of 86….

The reason for this difference is partly due to the fact that the market crashes that occurred in 2002 and 2008 were very damaging to my retirement portfolio. Even if during retirement I will be more conservative, a financial crisis like this one hurts badly, even conservative investors.

Additionally, you can never expect the outcome of a simulation to be exactly the same as what is going to happen in the financial markets, this is due to the statistical randomness of financial performance. Hence, a buffer should be taken into account when planning for the future: the outcome can be better than expected, but it can also be worse leaving you with a financial deficit at the end of your life.

This is the concept of risk inherent to investing in financial products, i.e. there is a potential downside. If the downside happens before you retire, you can still make it up by working longer or by saving more, but if it happens when you are not able to work anymore, things can turn sour.

It is therefore advised to fully understand the potential downside before investing, because risk is inherent to the markets, and when it happens it is too late.