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Why a Soaring Stock Market Is Wasted on the Young

The news media typically covers stock markets using one exceedingly simple frame: Market goes up, good! Market goes down, bad!

And this much is true: If you're in a stage of life when you are pulling money out of the market, like a retiree living off accumulated savings, a higher stock market is indeed great news. But some simple experiments with four hypothetical people show why that calculus is a lot more complicated for younger people. The key lesson: The dramatic runup in the American stock market over the last five years is actually bad news for many young adults who are just embarking on saving for retirement.

A television host points to a graph on a screen at the New York Stock Exchange in New York.
Getty Images
A television host points to a graph on a screen at the New York Stock Exchange in New York.

When you invest in some broad index of the stock market, such as any of numerous vehicles that let you buy into the Standard & Poor's 500 stocks, you are in effect buying a claim on the future profits of all major listed companies. When the stock market goes up, you have to pay more for that future stream of profits; when it goes down, you are paying less.

But as it turns out, it matters a great deal for most people when a rise in the stock market occurs.

But not for our first hypothetical saver, Plutocrat Pete. Pete has a rich uncle who gives him $300,000 when he turns 30, which he earmarks for savings and won't touch until he's 60. Now consider three scenarios. In one, the stock market returns precisely 7 percent a year each of the 30 years. In the second, the market returns 50 percent a year for the first five years, and then zero return for the ensuing 25 years. And the third scenario is the reverse, returning zero for 25 years and then 50 percent a year for the last five years.

These possibilities each have the same compound annual growth rate over the 30-year period. So Pete is in equally good shape no matter which one materializes. In all three of those scenarios, when Pete turns 60, his original $300,000 from his uncle has turned into $2.28 million.

Most of us, alas, aren't Plutocrat Pete. Most of us have to save for retirement ourselves, not with one giant chunk of cash we obtain when we're young but by squirreling a little away each year.

Most of us, in other words, are more like Steady Eddie, who puts $10,000 a year in his retirement account starting when he turns 30, and stops at 60. In other words, the total amount he invests is the same as the $300,000 that Pete had, except Eddie saves it over time rather than having the money upfront.

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In Steady Eddie's case, the stock market returns 7 percent each year. It works out fine for Eddie. With steady contributions and steady returns, the $300,000 he puts in over 30 years has turned to $1.01 million by the time he is looking to spend it. Not bad!

But he's not doing nearly as well as Lucky Laura. She puts the same $10,000 a year into her retirement account, but the pattern of returns over her career just happens to be backloaded — it is the scenario described above of zero return for 25 years followed by five years of 50 percent returns.

As a result, by the time those big returns are occurring, Laura has built a great stockpile of savings. So in the end, she does nearly as well as Plutocrat Pete did. Her $300,000 invested has turned into $2.01 million. Nice!

But what if the reverse had happened, with all of the returns frontloaded into the first five years, followed by 25 years of zero returns? Alas, that is the world that Unlucky Umberto encountered. And even though he saved just as diligently as Eddie and Laura, he suffered because of bad timing.

While Umberto might have been thrilled with the returns in his first few years of investing, they came at a time when he had very little invested. Because of lower (actually zero) future returns, he lost out, big-time.

Umberto ended up with only $448,200 in his retirement account after 30 years, fully 79 percent less than Lucky Laura, even though they both socked away the same $10,000 a year.

Read MoreWant some smart money advice? Ask a 25-year-old. No, seriously.

While these are all radically simplified examples, there is a real chance that current young adults are facing a situation a bit like Unlucky Umberto's. The Standard & Poor's 500 index has returned 175 percent since March 9, 2009, just over five years.

Part, and perhaps most, of that rally has been driven by rising confidence in the economy, and to the degree that higher stock market prices have coincided with a recovering economy and better job market, that's of course good news. After all, in order to save for retirement, a young adult first needs to have a job.

But to the degree that the remarkable rally in stocks (and virtually all other assets) is cannibalizing the returns that otherwise would have occurred in the decades ahead, it's potentially bad news for people at the front end of their plans to save for the future.

Read More5 ways to win over Gen X investors

We can't all be Plutocrat Pete or Lucky Laura. Today's younger adults need to continue to save for the future, but they should cross their fingers that they're not actually Unlucky Umberto.

By Neil Irwin, The New York Times

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