Investment horizon: Is it relevant?

Question

It is commonly assumed that investors with longer horizons should allocate a larger fraction of their savings to risky assets than investors with shorter horizons.. if our savings are invested in a risky asset such as stocks.. over a short horizon we could lose a substantial portion of our savings.. what's the rationale behind this argument?

Over a long horizon, favorable short-term stock returns are likely to offset poor short-term returns, so in that case it is more likely that stocks will realize an actual return close to their expected return.

There's that notion that above-average returns tend to offset below-average returns over long horizons. The idea of time diversification may be clearer if we think about the probability of losing money as a function of horizon. Let us assume that the S&P's return equals 10 percent and its standard deviation equals 15 percent, we find there is a 26 percent probability that the S&P 500 will generate a negative return in any one year. Given a ten-year horizon, however, the probability that the S&P 500 will produce a negative return falls to only 2.2 percent. This does not imply that it is just as probable to lose money in any one of the ten years, it merely reflects the tendency of above-average returns to cancel out below-average returns.

Answer 1

Very interesting question.

The rationale behind the investment horizon is based on risk/reward.

It is commonly accepted that there's a higher risk typically associated with a higher expected returns. For instance, venture capital has a higher reward and risk vs. junk bonds which have higher risk than most stocks which have a higher reward and risk vs. bonds and so forth.

That said, the reasoning for being more risk seeking over a long term is as follows. Over longer periods, higher expected returns should yield higher returns and growth despite volatility in the results. Said another way, if you have 30 years, your portfolio could withstand a 3 yr recession and probably recover fine whether you invested in stocks or bonds. However, since stocks have a much higher rate of return than bonds, over 30 years, the difference in the amount amassed could be staggering. $10,000 invested in a 4% return for “safe” bonds over 30 years would be worth $43,219. Whereas, a 10% return on stocks over the same period would be worth $174,494. Quite a difference!

So here’s the other area where the time horizon comes into play. If you have a shorter time horizon, and something bad happened, you might not have enough time to recover your initial investment, let alone build it! The probability that you could lose a substantial amount of your invested capital is much larger than over a longer period. For example, if you flip a coin twice, you could get all heads 25% of the time even though the probably of getting heads on any given flip is only 50%. However, if you flip a coin 100 times, the odds of getting all heads becomes very, very remote. In fact, over the long run, odds are much better that you get the expected 50 heads (plus or minus) just as you would expect.

In summary, going back to the recession example. A three year recession in a five year time horizon could mean the difference between retiring with your anticipated and expected annual return/income (using safer instruments), vs. having to work at Walmart while “retired.”

Hope that helps!


P.S. Nice avatar!

Answer 2

The greater the risk, the greater the reward is how the old saying outs it.

What we percieve as a great risk is sometimes a low risk and high reward. People like to buy stocks that are highly valued and "on a run" because they don't want to miss out. If you could buy Ford for a dollar fifty it would probably work out very well. If you bought Microsoft today you are paying a very high price for a dollar of earnings, therefore the odds are much lower that you will make any money. This is the classic battle of the growth stock verses the "value" stock. Good money "can" be made with either style, but if you have a longer horizon I vote for the value style. Todays growth stocks are a flash in the pan. We just don't know when it will be over and dividend return and valuations will creep or plunge to their long time averages. Make periodic investments in solid issues.

Answer 3

Since risky assets' returns are variable, statistics show that within a short horizon they are likely to be down, however over the course of a long horizon the variability usually nets out to a positive gain. I have many "risky" stock investments and have seen this to be a relatively true assessment.

Answer 4

Because the price of stocks can fluctuate widely over the short term but has a general tendency to go up over the long term...

So if you buy for the long term you have a very strong probability of realizing gains... If you buy short term there is a risk that you are buying at a temporary peak and that when you sell the price will have dropped significantly resulting in a loss...

Answer 5

time horizon doe snot mean that you make an investment and forget about it , the meaning is that you are prepared to wait for a long period for superlative returns, for this you have to do your home work and know the fundamentals of the business you are investing in as you are now a part of the business. If the business is not performing as per you expectation then you have to switch to a new company. But u have to be always alert with your investments long term or short term doe snot matter

Answer 6

If you invest in 10% of your money in 10 volatile stocks, and one jumps up 2,000%, and all the others lose everything, you have have a 10% gain in a short time.

Answer 7

I like hlsj's answer. Very insightful and astute.

The logic or premise that is the foundation of the postulated argument is predicated on the following assumption:

"As it was in the past, so shall it always be".

In other words, the logic stipulates that things will continue into the future as they have in the past. The other posters are correct that in the short term, markets and whipsaw and thus deplete ones account equity, while in the long run equities have risen over all, ergo, a longer term perspective would have resulted in net positive return. Thus, a statistical net positive return would warrant the logic of placing a larger percentage of ones funds in the market to capitalize on the longer term net positive gains.

But to leave the argument solely on that basis my be premature and short-sighted. Let me see if I can explain. The majority will use the logic that "if you have invested 'x' amount of dollars in the Dow in 1900, it would be worth 'x+' amount of dollars now". And that is indeed true. But, how many people be around for 100+ years?

The average individual will have about 30 good years to invest prior to retirement. You figure, getting out of school and getting a job and your own place and being financially set to being investing, let's say late 20's in age. If you get married, a little longer. So, let's make the assumption that from ones 30th birthday till retirement of 65 years old, you have 35 years to invest before retirement.

Now, let's take a look at some figures. From about 1850 till 2000, the market grew from 50 points to 11,733 or a total of nearly 11,700 points. Based on that broad perspective, yes, that longer term view has see a very large net positive return. but, let's break that down. From 1924 to 1929, the Dow grew from 100 points to about 400 points. When the market crashed, the index bottomed around 50 points. It took 25 years for the index to return to pre-crash levels. Now, let's assume that the average individual got in just prior to the crash at 30 years of age. That means, they'd be 55 years old when they finally recouped their money. That's just to get back what they lost. Their money still needs to return a sufficient amount of profits in order to support their retirement. That means their investments must perform in such a manner as to see returns that will support their retirement and must do so within a 10 year time frame (age 55 to recover their money and 10 years till retirement at age 65). If they got into the market in 1924, they would have still be starting from a lower level, since the market bottomed at 50 points lower than when they started.

The bear market that ended in 1982 started about 17 years earlier in 1965. In 1965, the Dow was around 1,000 and ended at 772. For 17 years, the index went nowhere. So, the average individual who in they began investing at age 30 in 1965 would have seen no gains, just a relatively minor loss.

But, on the flip side, if the person has started investing in the index at the market bottom in 1932, the would have seen the Dow go from about 50 to 1000 in 1965, a 2000% gain in 33 years. There were periods during that 33 years where the market posted a net loos. For example, a net loss of 48% occurred in the market for a period of 5 years from 1937 to 1942. Other time frames include 1946-50 and 1956-59. Also, if an average individual of age 30 has begun investing in 1982 during the market bottom, they would have seen a 1300% return in the 18 years from 1982 to 2000.

Of the 11,700 points that have been garnered in the 150 years from 1850 to 2000, the bulk of that occurred during the 18 years from 1982 to 2000. From 1850 to the bear market bottom in 1982, the Dow increased a whopping 722 points (50 points in 1850 and 772 at bear market bottom in Aug. 1982). So from the time of the bottom during the depression to the bottom of the bear market in 1982, the Dow has not gain that much in point value. From 1982 to 2000 the Dow went from 772 points, to 11,733 - almost 11,000 points. It took the Dow 132 years to grow 722 points, but only 18 years to grow 11,000 points. That is not the norm, it's a once in a lifetime type of occurrence.

I stipulate that the majority that subscribe to the above referenced argument are doing so based the overall picture ranging from the beginning of when records were kept till present day. Since people only have about 30-35 years of investing, one must therefore look at the longer term perspective relative to the current cycle in play.

Remember, If one had begun investing in 1932 or 1982, they would have gotten in at the beginning of bull markets and seen substantial returns. But if they began investing in 1929 or 1965, they would have gotten in at the beginning of bear markets and seen either flat returns or heavy losses.

Before one subscribes to allocating a larger portion of their funds to a longer term perspective, one must take into consideration what the current long term cycle is and where in that cycle we are currently.

The Dow runs on roughly a 17-18 year secular bull/secular bear cycle. If one has an average of about 30 years of investing prior to retirement, one can not afford to subscribe to the longer term perspective of larger fund allocation if they are getting in early on in a secular bear cycle. Ones account equity can be just as severely depleted if they allocate larger portions of their savings early or midway into a secular bear market as easily as the rapid markets swings and deplete an account equity with the shorter term perspective.

Whether it be longer term or shorter term, one must temper their investment horizon philosophy with the primary market cycle that the index is currently transitioning through.

Answer 8

Forget the question girl. Damn! Is that avatar you?

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