I was helping a younger friend (he's entering his mid 20s, just starting his career) understand investing in general, and trying to teach him not to chase returns, and not to react to the market's tide... thought the following e-mail might help others...
The key is... to flip that internal mechanism that freaks out when the market drops, and gets euphoric when it's rising. Really, you want the market to be down (while you're accumulating and adding money) particularly in the earlier stages.
Realized while rereading my last message to you that a lot of the terms are not common. CAGR is the most important one, it's just yearly average return. So, if you had a CAGR of 10%, that means your money is going up 10% a year... CAGR is simply a term to level off the average return for a long period of time down to a linear line. The reality is that the market is anything but linear. It'll actually do something like +15%, +12%, -20%, +40%, +3%, -5%, 19%
CAGR is taking all of those figures and multiplying them out... which would be 68% in total over 7 years. Then doing a log function to get a figure that gets to the same 68% in those 7 years to represent an "AVERAGE" yearly return. In this case... that's 7.7%
If you told someone... you'll get 7.7% return a year for 7 years on your investment, they'd be like "sweet, awesome!" and they'd assume their $10,000 will turn into $16,800 and would just smile the whole way. However, the reality is someone actually sees the above random returns... which end up getting them to $16,800 so long as they don't freak and divest midway because of being scared when things go down. It would look like this (with the above string of 7 returns)
No matter how or when the returns come (you can rearrange them and their order) you'll always end up with that final figure (a total growth of 68% - which is an average of 7.7% a year). That's the key I was getting at last night... about not adjusting your portfolio. Because people ALWAYS change things when they aren't doing well, and they pick stuff that has been doing well. That's the worst way to do it (Buy high Sell low). It's human nature though.
It gets interesting, and things chance, when you're adding money as you go... if I were to start again with $10,000 and add $5,000 every year to the total it would go like this:
Now what is really fascinating... let's assume you get those same returns, but you end up with the WORST stuff early and the BEST at the end. Most would give up and stop investing, but this example proves how backwards that thinking is. Horrible investing markets early in your accumulation time is an amazing opportunity. Watch when I organize the returns in order from lowest to highest... doing the same as above (starting with $10K and adding $5K every year)
$16,150 (-5%) (at this point someone would be rather depressed having set aside $20,000 total; but just watch)
$83,017 (40%) wow... your total of $45,000 savings grew $38,000 in 7 years
The market fluctuates, but has longer term trends and it always regresses to a long term path. So in general, if the market has done really well recently, it's pulled back down over the coming years... if it's done really poorly, then it's pulled back up. Always to straddle that long term trend upwards (which over the last 150 years is right at 10% a year, or as a more accurate figure... about 7% after inflation - that's the 100+ year CAGR of the market).
This is why you should secretly hope for lackluster returns over the next 10 years as you start to save. The inverse of the above example (best years first, and worst last) is less appealing:
$31,200 (20%) feeling awesome about your $20,000 investment reaching $30K in two years huh?
$52,596 (-20%) ouch... your total of $45,000 savings only grew $7,596 in value over 7 years.
These examples get WAY more pronounced over longer periods of time
Take note that later in your life you'll reach a period of time where everyone is euphoric about the market and how well it's done recently... people in bonds will be itching to put everything into Stocks... that's a peak. It's the time you want to move to safer investments. Conversely, there will be periods of time in your career (I'm guessing sometime in the 30s) when we'll have another horrible decade like the ones we saw between 2000-2008 where the DOW dropped to 7000... THAT is the time you want EVERYTHING in stocks (if you can sleep at night). Look at the market the last 10 years following that horrible period... it's tripled to $20K.
Right now the market is over the 150 year line, but it's not egregiously far over it. If the DOW gets up to 22,000 then I'd say it is. The DOW line long term trend should be around $17,500 right now. And that line goes up 10% a year... so expect the market to deviate down about 20-30% over the next 5 years. When I say deviate down though, that's down from the trend of 10% up. If that makes sense... so reality is that the market very well could be about where it is right now 3-5 years from now. It'll just be a lackluster period... and after that it'll shoot up again. Comes and goes in waves. Key is to stop trying to guess when those waves are coming and going... and just invest consistently. At your age, you'll do great to just get started and stick to the plan.