The Importance of Time Horizons in Investing
March 27, 2019
The following set of charts are great visual aids for showing the benefits of long-term investing in the stock market. The charts can help investors plan and set proper expectations.
Two terms to understand the charts are below.
DFA Domestic Balanced Strategy Index: This is a diversified blend of Dimensional US equity indices. The index is weighted roughly two-thirds large cap and one-third small cap, along with a tilt towards value. Indices are hypothetical and cannot be invested in directly.
One-Month US Treasury Bills: This is a commonly used proxy for the risk free rate of return on cash.
This chart tells almost everything we need to know about investing in stocks for a 12-month period. If that’s your planned holding period, don’t do it! Not only will the investment frequently underperform cash, it can lose money. Sometimes a boatload of money with 12 month returns ranging from approximately -50% to +80%! On a year by year basis, extremes are normal.
If the investment will need to be liquidated for a lump sum of capital within the next 5 years (i.e. a home down payment, car purchase, tuition payment or a readily available emergency fund), it’s probably best to keep most or all of it in cash equivalents.
This chart is less noisy, but there are still periods when stocks have lost money over a 5-year period and even more when stocks underperform cash. For this time horizon, it’s still reasonable to keep the lump sum of capital mostly in cash substitutes. Investors with the willingness to accept risk could consider keeping a modest portion in stocks with the awareness of the potential for loss.
At 10 years, the advantages of investing in stocks is seen more clearly. However, history shows there is still no guarantee. For example, as recently as the bottom of the 2009 crisis, the DFA index barely produced a positive return over the prior 10 years and would have underperformed cash. Note that an S&P 500 only investor would have done even worse, losing about 30% of their capital during this period. This highlights the benefits of small cap and value diversification in the DFA index.
Experience teaches that many investors tend to think 3 years is a long time, 5 years is a really long time, and 10 years is an eternity. Yet history shows us that at even the 10-year time horizon, expected return relationships (such as stocks to outperform cash) don’t always materialize. This must be true, otherwise there would be no risk. Investors with 10-year time horizons before needing to liquidate funds (a frequent example of this is a child’s 529 college fund), should invest a portion of the capital in bonds and cash with plans to increase this ratio each year. Of course, all of this depends on each individual’s willingness and need to take risk, which is why financial planning is a personalized case-by-case process.
The next chart shows the 20 year rolling returns. Many investors in their 50’s and 60’s don’t think this time horizon applies to them because they envision retiring at age 65. What many forget is that the time horizon for retirement planning is different than one for paying for a child’s college education. When a child goes to college, the expected depletion of the account is typically within 4 years. A couple entering retirement usually needs to make the capital last for up to 30 years by taking a series of smaller annualized withdrawals. A child entering the first year of college should typically have very little in stocks while a couple entering their first year in retirement may still want to have the majority in stocks.
We see that there are no 20-year periods where stocks underperform cash for the DFA index since 1950. If a retirement investor follows the conventional approach of a 4% safe withdrawal rate, 96% of the portfolio remains invested each year for growth. Annualized stock market returns are much more stable historically once to and beyond this timeframe with the gap between the best and worst periods ranging from approximately +5% to +19%.
Last, study a 30-year period; the contrast between this chart and the 12 month chart is significant.
At the one-year time horizon, it’s hard to justify investing in stocks. At the 30-year time horizon, investors may wonder why you’d invest in anything else. Risk for short term capital is volatility of principal, while risk for long term capital is erosion of purchasing power due to inflation. Good financial planning considers the time horizon for each objective and invests the capital accordingly.