Buy and Hold (Return vs Risk)

Why Investment Risk Increases Over Time

August 10, 2010, 11:26 AM

By CARL RICHARDS

Carl Richards

Carl Richards is a certified financial planner and the founder of Prasada Capital.

Spend any time hanging out with traditional financial services salespeople or in the investment section of Barnes & Noble and you’ll no doubt hear the claim that risk declines over time.

This story is often accompanied by an “educational” piece that looks something like the sketch above. The message is that over time, the range of potential investment returns narrows toward a long-term average of about 10 percent.

In other words, when you look at the best and worst returns for the stock market for any one-year period, you could have lost over 40 percent or gained over 60 percent. That’s a really wide range.

But when you look at 20-year periods, the worst average annual performance was a gain of around 3 percent with the best being about 15 percent. That’s a much more narrow range. Over 30 years, things get even closer to the average.

The problem is real people in the real world don’t really care about percentages. We care about dollars. No matter how hard you try, you can’t pay for food, college or retirement with a bucket full of percentages.

And when we measure the same range of potential outcomes over time, only this time we do it in dollars, you get the opposite picture. The potential outcomes get wider over time.

If you happen to earn 5 percent instead of the 7 percent you planned on, it will make very little difference 12 months from now. But in 20 or 30 years, you will end up in a greatly different place.

Think of it as a cross-country flight leaving from Los Angeles and heading to Miami. If you’re a half-inch off when you take off, you will hardly notice when you fly over Las Vegas. Fail to make a course correction, however, and you run the risk of ending up in Maine instead of Miami.

It’s a wild paradox, but most of the educational stories and tools used by the investment and personal finance industry are focused on investments, not investors, and on percentages, not dollars. A study released recently came to a similar conclusion using much more detailed reasons as to why, but the message is the same. Risk actually increases over time, contrary to the expectations of the industry.

This is part of the reason that financial plans are worthless, but the process of planning is vital.

If you base your plan on earning the long-term average return of the stock market and never make course corrections, you’re at great risk of ending up someplace other than where you planned. On the other hand, if you set a course and then make slight course corrections when you find you have veered off, you can home in on your destination.

http://bucks.blogs.nytimes.com/2010/08/10/why-investment-risk-increases-over-time/

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Risks and Investors' Holding Period

Risks and Investors' Holding Period

Total Real Returns

The focus of every long-term investor should be the growth of purchasing power - monetary wealth adjusted for the effect of inflation.

The growth of purchasing power in equities not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social, and political environments over the past two centuries, stocks have yielded between 6.6 and 7.0% per year after inflation in all major subperiods.

The long-term perspective radically changes one's view of the risk of stocks. The short-term fluctuations in the stock market, which loom so large to investors when they occur, are insignificant when compared with the upward movement of equity values over time.

Risk and Holding Period

For many investors, the most meaningful way to describe risk is by portraying a worst-case scenario.

Stocks unquestionably are riskier than bonds or bills in the short run.

• In every 5-year period since 1802, the worst performance in stocks, at -11% per year, has been only slightly worse than the worst performance in bonds or bills.
• For 10-year holding periods, the worst stock performance actually has been BETTER than that for bonds or bills.
• For 20-year holding periods, stocks have never fallen behind inflation, whereas bonds and bills once fell as much as 3% per year behind the rate of inflation.
• For 30-year periods, the worst annual stock performance remained comfortably ahead of inflation by 2.6% per year, which is just below the average 30-year return on fixed-income assets.

It is very significant that stocks, in contrast to bonds or bills, have never offered investors a negative real holding period return yield over periods of 17 years or more. Although it might appear to be riskier to accumulate wealth in stocks rather than in bonds over long periods of time, precisely the opposite is true. The safest long-term investment for the preservation of purchasing power clearly has been a diversified portfolio of equities.

As the holding period increases, the probability that stocks will outperform fixed-income assets increases dramatically.

• For 10-year horizons, stocks bea bonds and bills about 80% of the time.
• For 20-year horizons, it is over 90% of the time, and
• For 30-year horizons, it is virtually 100% of the time.

Although the dominance of stocks over bonds is really apparent in the long run, it is more important to note that over 1- and even 2-year periods, stocks outperform bonds or bills only about 3 out of 5 years. This means that in nearly 2 out of every 5 years a stockholder will fall behind the return on Treasury bills or bank certificates. The high probability in the short run of underperforming bonds and bank accounts is the primary reason why it is so hard for many investors to stay in stocks.

Investor Holding Periods

Some investors question whether holding periods of 10 or 20 or more years are relevant to their planning horizon. Yet these long horizons are far more relevant than most investors recognize. One of the greatest mistakes that investors make is to underestimate their holding period. This is so because many investors think about the holding periods of A PARTICULAR stock, bond, or mutual fund. But the holding period that is relevant for portfolio allocation is the length of time the investors hold ANY stocks or bonds, no matter how many changes are made among the individual issues in their portfolio.

Average Investor Holding Period

Let us study the average length of time that investors hold financial assets based on gender and the age at which they BEGIN purchasing such assets. It is assumed:

• That individuals accumulate savings during their working years in order to build sufficient assets to fund their retirement, which normally occurs at age 65.
• After age 65, retirees live off the funds derived from both the returns and sale of their assets. It is also assumed that investors either plan to exhaust all their assets by the end of their expected life span or plan to retain one-half of their retirement assets at the end of their expected life span as a safety margin or for bequests.

Under either assumption:

• Individuals who begin accumulating assets in their 30s will hold financial assets for 40 years and more.
• Even investors who begin accumulating assets near retirement will have a holding period of up to 20 years or more. It should be noted that the life expectancy for males is now about 82 years; for females, more than 86 years; and for either spouse, about 90 years.
• Many retirees will be holding assets for 20 years or longer. In addition, if the investor works beyond age 65 , which is increasingly common, or plans to leave a large percentage of assets as a bequest, the average holding period is even longer than those indicated.

Conclusion

No one denies that in the short run stocks are riskier than fixed-income assets. In the long run, however, history has shown that this is not the case.

There is still much uncertainty about what a dollar will be worth two or three decades from now.

Historical evidence indicates that we can be more certain of the purchasing poer of a diversified portfolio of common stocks 30 years hence than we can of the final payment on a 30-year U.S. government bond.