Are Stocks Less Risky the Longer you Hold Them?
What do you know about time diversification? Sure, we understand if you need the cash soon, don’t invest in stocks. But, if you don’t need to money for a long time, people say that stocks are less risky over the long run. Is that true? Does time diversify your portfolio?
Time diversification states that the volatility of assets decreases over long periods of time.
Some, however, consider time diversification a fallacy. While the probability of losing money might go down over time, the amount of money at risk becomes much larger!
Let’s explore time diversification and think about a way to get around the fallacy.
Time Diversification and Returns Over Time
We are pretty used to looking at the standard deviation around stock market returns. This is the volatility of the stock market. The longer time period, the smaller the standard deviation of an asset over time.
Instead of standard deviation, we can also look at the returns over 1-, 5-, 10-, and 20-year rolling averages. The average rolling returns also get smaller (less variable, that is) over longer periods of time.
Above, you can see that large caps equities (in grey) can have 1-, 5-, and 10-year periods of negative returns. Over a 20-year period, you may expect (historically) a positive 4% to 18% return.
But note how the error bands (or the likely returns) decrease over increasing time periods. This means volatility decreases over time!
Next, bonds (green) can also have negative rolling returns until you get out to the 20-year rolling average. Wow.
What about a 50/50 portfolio (in light blue)? Compared to either extreme, you are less likely to get a negative return without sacrificing much positive return.
Thus, future returns narrow to the average expected return over time. Makes sense. How does that tie in to Time Diversification?
Time Diversification and Volatility
Let’s get back to the idea of time diversification. If you only have a 5-year timeframe to invest before you need the cash, you know that there is the possibility, regardless of the asset allocation, you might not have a positive return!
Thus, one typically recommends cash or cash equivalents for short investment time periods. You only buy equities if your time frame is long enough.
Time diversification, again, states that the volatility of returns decreases over time. However, think about it this way: year 29 of your 30-year investment timeline has the same actual volatility as year one! That is, there is still the real risk that you could lose 43% of your large cap equity investment in the last year when the stakes (and the absolute amount of money invested) are much larger!
This is the Fallacy of Time Diversification. Sure the chance of a loss may be the same every year of the cycle, but the impact can be huge late in the cycle.
The Fallacy of Time Diversification
As you invest over the years and the amount invested grows, you have more to lose!
For instance, if you are putting in 20k a year, then you might lose 50% the first or the last year of a 30-year investment horizon. If you lose the first year, you are down 10k. If you lose the last year, however, you might be down $1M if your portfolio had grown to be worth $2M. Which loss actually hurts worse?
Thus, while you are just as likely to suffer a loss year one and you are year 29, the loss is much more painful in year 29! The probability is the same, but the magnitude of the loss is much greater as time passes.
While stocks seem less risky the longer you hold them, this is only true ON AVERAGE and not when you look at a string of past returns and only have the unknown future to ponder.
Yet you need that last doubling!
Why You Need the Last Doubling
Interestingly, it is the last doubling that usually makes you “rich.”
That is, think about the rule of 72. If you get, on average, 10% returns each year, it will take your money 7.2 years to double.
The first doubling, if you have 100k invested, you get to 200k. The last doubling in a 30-year cycle, your money goes from 800k to $1.6M.
Thus, the last doubling is the one that really adds to your portfolio. You get 8 times more from the last doubling than the first!
Yet, this is exactly when you cannot take the risk! Again, each year is not an average, each year has actual returns. You are just as likely to lose money the last year as you are the first year of this cycle.
If you need your money to double one last time in order to be able to retire, you might be taking on a lot more risk than you can tolerate. How can you mitigate that risk?
Ways to Mitigate the Fallacy
How can you mitigate the risk of Time Diversification? Consider:
Remember, it is all about your pre-retirement glidepath! You need to have enough risk to get that last doubling, but not so much risk that you get thrown out at the plate.
Fundamentally, the fallacy is a fallacy because you don’t keep the same investment for 30 years. You de-risk with time. Stocks are more risky the longer you hold them, but your portfolio changes over time.
How Long is Long Enough?
Are stocks less risky the longer you hold them? No! They are just as risky every single year, on average, as the year before.
Think about the pre-retirement glidepath and de-risking to mitigate this risk.
In fact, you can mitigate the the fallacy of time diversification AND sequence of returns risk by changing your asset allocation towards the end of a long investment horizons.
So, how long do you need to remain invested in risky stocks?
That is, how much time do you need to have before you chose equities over a risk-free return?
Above, you can see the percent of time that the risk-free rate is better than a stock index Source.
In the beginning, most years (70% of the time) stocks beat no-risk treasury bonds. It gets to 80% by year 7, then has an interesting trend upwards (which may reflect the length of a business cycle, 7-11 years).
Finally by year 15, you have a 95% chance of beating treasuries with stocks, and this gets to 100% at year 20.
That is a long haul to ensure that you beat the risk-free rate!
Summary: Are Stocks Less Risky the Longer you Hold Them?
In summary, it is useful to consider time diversification. Remember, stocks are not less risky the longer you hold them!
The risk year-to-year of a market drop is the same, and as your assets grow, so does the risk of a major loss. The long-term uncertainty from year-to-year volatility doesn’t change over time!
Simply said, you actually have MORE risk the longer you are invested in equities along your expected time horizon of investment.
The goal: understand the risk to your portfolio over time. When you are young, volatility is actually not a risk. Only when close to retirement does volatility matter. Thus, risk in equities actually increases over time, not decreases.
Remember, stocks are always risky investments, even over the long haul. They don’t get safer the longer you hold them.