How much does luck affect your investment performance? © BrandX/PictureQuest

Extra8/16/2010 6:10 PM ET

The real key to investing? Luck

There's no 'normal return.' So your best bet is to start early, save regularly and hope the market doesn't trip you up.

By MarketWatch

Investors saving for retirement can find mutual funds that invest in almost any kind of asset, but they can't buy the one thing that will have the biggest impact on their nest eggs: luck.

Forget about who's the hottest fund manager, which is the best-performing fund or which sector appears to be the best bet. The biggest factor in long-term returns is how the financial markets happen to perform during the 30 or so years an investor puts money away for retirement.

Recent history has provided a fresh lesson in the power of chance, as many on the cusp of retirement were battered by a stock market that dropped almost 40% in a single year amid the crisis in the financial industry. But the crippling effect of a market swoon just before you leave the work force is only part of the story.

The bigger issue is that if your career coincides with a relatively flat period for the markets, there's going to be a natural limit on how much you can hope to reap from your investments. After all, study after study has found that over long periods, very few funds outperform the market.

It's a sobering thought. If so much of your fate as an investor is out of your hands, what can do you do?

Focus on the things you can influence, said Fran Kinniry, the head of Vanguard Group's investment strategy group. That means going back to some of the traditional advice about investing for retirement: Start saving as early as possible, save as much as possible, diversify and pick low-cost investment options. It also means you shouldn't rely on projected returns based on historical averages to make up for inadequate savings. And you shouldn't think that your skill or your fund managers' skill in choosing investments is going to save the day.

There is no normal

Investors tend to peg their expected returns to certain facts they have learned, such as the average annual 10.9% total return of the Standard & Poor's 500 Index ($INX) over the past 30 years. But history -- especially selective history -- can lead people astray.

That 30-year return, of course, takes account of some violent swings in the markets along the way, like the 37% decline in the S&P 500 in 2008, as well as the index's 38% gain in 1995. So an investor alarmed by the latest dramatic drop in share prices might soothe himself with the thought that over time his portfolio's performance will return to the historical norm.

The problem is, there really is no historical norm.

Research carried out by Ibbotson Associates shows just how different outcomes can be, depending on when you invest. Ibbotson, a consulting unit of fund tracker Morningstar, created a hypothetical portfolio of 60% stocks and 40% bonds that rebalances at the start of each year.

The study found a tremendously wide range of returns for various 30-year periods. For instance, $100,000 invested in 1946 would have grown to about $1.15 million in 1976, but the same amount invested in 1976 would have delivered about $2.27 million in 2006.

But those are totally different time periods. A better illustration of the random nature of returns is their range in time periods that largely overlap each other.

For instance, $100,000 invested in 1925 would have yielded about $1 million 30 years later, while the same amount invested in 1927 would have grown to only about $760,000 by 1957. And an initial $100,000 investment made in 1964 would have yielded $1.47 million in 1994, while that investment made in 1965 would have grown to about $1.78 million in 30 years.

"You have to realize that you don't know how your 30-year (investing) period is going to go," said Thomas Idzorek, the chief investment officer and director of research at Ibbotson.

But academic studies have found that most people don't fully appreciate the role of chance in their investment results. "We have an asymmetric view of good and bad luck," said Shlomo Benartzi, a business professor at the University of California, Los Angeles. "It's well established that people attribute bad luck to randomness, but then attribute good luck to their own skill."

That means a lot of investors might be feeling a bit too smug for their own good. Because, despite the collapse of share prices that's still fresh in everyone's memory, the past 30 years have been wildly successful for investors. Though the S&P 500 Index is flat for the past decade, it's still roughly 10 times higher than it was in 1980. Bonds have also delivered strong returns, and the average home price has more than tripled.

"The economic successes of the past 30 years have given us greater and greater confidence in our own skills," said John Payne, a professor of business administration at Duke University.

And that confidence might be setting us up for a fall. Because if the markets deliver lower returns over the next three decades than they did over the past three, many investors who assumed they could at least match the previous period's results will be left with savings that fall short.

Continued: Fashion doesn't pay

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