Let’s illustrate this in a simplified world to make this vulnerability very clear and prominent. Americans are a very self-reliant people who believe if you work hard and do what you are supposed to be doing, then things are going to work out. So let’s consider some hypothetical individuals who are doing everything absolutely right (based on our state of knowledge) with regard to their retirement planning. When retirement is still 30 years off in the horizon, they begin saving 15% of their salary at the end of each year.
In our simplified world, these folks don’t have to worry about health risks, disability, or economic shocks to Main Street which might cause them to lose their jobs. They are able to continue work over the subsequent 30 years earning a constant
Inflation risk
Inflation risk is the risk that inflation will reduce your purchasing power in the future, either because inflation was higher than expected, or inflation outpaced your investments.
" style="box-sizing: border-box; color: rgb(67, 72, 77); text-decoration-line: underline; border-bottom: 1px dotted; font-size: inherit !important;">inflation-adjusted salary.
As well, unlike in real life, there is no uncertainty with regard to investing. There is risk, but this risk is understood. Each year the market provides a 7% real return on average, but the actual return is going to fluctuate around this real return with a standard deviation of 20%. So while one does not know what the year-by-year returns will be, they do know that returns will fluctuate around 7%, and with 30 years of returns the average (arithmetic) return each investor earned over their career will be somewhere close to 7%. Their wealth will not compound at this rate, as with volatility a given percentage drop in the portfolio requires a larger percentage gain to get back to where they started, and the math shows that the compounded growth they can expect for their portfolio is 5% (7% – 0.5 * (20%)^2).
So these folks play by the rules, do everything right, don’t experience any health or unemployment issues, and understand the underlying return process that affect their portfolios. Saving 15% at the end of each year and with wealth compounding at 5%, they fully expect to reach retirement with a portfolio equal to 10 times their salary.
Where do they actually end up?
The following figure shows a Monte Carlo simulation of a time series chart for 151 hypothetical investors who work and save for 30 years and get 30 years of market returns, but who differ only in which 30 year period they worked and saved in this 180 year simulated historical time frame.
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