One argument underlying the notion of holding risky assets in long-term portfolios is time diversification. Time diversification holds that above-average returns tend to offset below-average returns over a long enough period. It’s based on the concept of reversion to the mean: Eventually periods of low and high returns converge back toward their average.
The inherent problem with average returns is that they may not occur during your investing period. Though the range of what’s considered to be typical narrows with time, there is the possibility of returns not being typical over your investing time horizon. The very good 10-year period of 1990–1999 and the lost decade of 2000–2009 are examples.
Returns can be above-average or below-average but still be typical. These are the more likely scenarios, though they are never guaranteed.
Another risk with counting on time diversification is the sequence in which returns occur over your investing time horizon. Having low returns when starting out to save for retirement and high returns as retirement approaches is more favorable than the reverse. At the beginning, there is less money at risk, so periods of low returns will have a small impact in absolute dollar terms. As retirement approaches, there is a larger portfolio to benefit from the gains. It’s better to realize a 15% return on a $1 million portfolio (a $150,000 increase) than to realize the same return on a $10,000 portfolio (a $1,500 increase). Retirees taking withdrawals prefer the opposite: having favorable years occur early in retirement to profit from growth in the larger pool of investment dollars.
One way to view the impact of time diversification is to think of it in terms of terminal wealth. How much money will you have at the end of a given time horizon? Mark Kritzman, CFA, gave some examples to show the potential variances in a 2015 Financial Analysts Journal paper (“What Practitioners Need to Know ... About Time Diversification”). We’ve republished them in the table on the right side.
The dollar amounts are the minimum and maximum outcomes that can be expected for a $100,000 portfolio invested in the S&P 500 index, given a confidence interval of 95%. (This implies a high probability of returns being within those ranges.) The large spread between the lower and upper boundaries indicate the very wide range in terminal wealth that could occur over the various periods. Not included due to space reasons are the comparable outcomes for the same portfolio invested in a riskless asset (e.g., Treasury bills). At all intervals, it is either greater than or equal to the lower boundary of outcomes for the equity portfolio. Comparable terminal wealth for the riskless asset is $103,000, $115,927, $134,392, $155,797 and $180,611, respectively.
While the lower boundary may make an argument for decreasing exposure to equities, doing so prevents an investor from realizing returns close to the upper boundary. This is where longevity risk comes into play. Allocating to the riskless asset avoids losses in absolute-dollar terms, but massively increases the odds of outliving savings for an investor who currently lacks significant wealth and/or enough guaranteed income to fund retirement or other financial goals. To the extent that portfolio growth is required and there is enough cash flow to fund needs for the next two to five years, a higher allocation to stocks is warranted. The most likely outcome is wealth levels not near the lower or the upper boundary, but rather somewhere in the typical range sitting between those two extremes assuming a constant allocation.
The distance between the extremes is dependent on time horizon. Invest for a short period—such as a year or two—and returns can vary widely while still being in their typical range. Extend the horizon beyond five years and the variance narrows considerably, a key feature of time diversification. This is why conventional wisdom holds that you should only risk longer-term dollars in the stock market and use a combination of risk-free assets (cash savings, high-quality, short-term bonds, etc.) to fund shorter-term spending needs not covered by sources of income.
- The Sequence in Which Returns Occur Affects Your Wealth – This article demonstrates how merely changing the order in which annual returns occur will lead to very different outcomes for a retirement portfolio.
- Reduce Stock Exposure in Retirement, or Gradually Increase It? – One strategy for navigating sequence of returns risk is to reduce exposure to stocks heading into retirement and start raising it back once retirement begins.
- The Individual Investor’s Guide to the Top Mutual Funds 2019 – This popular guide helps to compare and contrast 727 funds. Plus, an expanded worksheet gives you detailed data on more than 1,600 funds.
- Older Workers Investing More in IRAs – A survey conducted by the Investment Company Institute found 68% of IRA-owning households were headed by someone age 45 or older.
The U.S. financial markets and our office will be closed on Monday in observation of President’s Day.
Fourth-quarter earnings season will remain busy even though the number of large-cap companies reporting is falling. Next week, 51 S&P 500 companies are scheduled to report, including Dow Jones industrial average component Walmart Inc. (WMT) on Tuesday.
The week’s first economic report will be the February housing market index, released on Tuesday. The minutes from the January Federal Open Market Committee (FOMC) meeting will be released on Wednesday. Thursday will feature the February Philadelphia Federal Reserve business outlook survey and January existing home sales.
Six Federal Reserve officials will make public appearances: Cleveland president Loretta Mester on Tuesday; Atlanta president Raphael Bostic on Thursday; and St. Louis president James Bullard, New York president John Williams, Philadelphia chairman Patrick Harker and vice chairman Richard Clarida on Friday.
The Treasury Department will auction $18 billion of two-year floating-rate notes on Wednesday and $8 billion of 30-year inflation-protected securities (TIPS) on Thursday.
- The Individual Investor’s Guide to the Top Mutual Funds 2019
- Minimizing Taxes With Asset Allocation
- Your Portfolio: Maintaining Perspective
The percentage of individual investors describing their outlook for stocks as “neutral” is at a seven-month high. The latest AAII Sentiment Survey also shows a drop in optimism and an increase in pessimism.
Bullish sentiment, expectations that stock prices will rise over the next six months, pulled back by 4.8 percentage points to 35.1%. Optimism is back below its historical average of 38.5% for the 19th time in 23 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 2.5 percentage points to 39.8%. Neutral sentiment was last higher on July 25, 2018 (41.6%). The increase keeps neutral sentiment above its historical average of 31.0% for the fourth time in six weeks.
Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 2.3 percentage points to 25.1%. This is the first time pessimism is below its historical average of 30.5% on back-to-back weeks since August 15, 2018, through September 5, 2018.
At current levels, all three sentiment indicators are within their typical historical ranges, though neutral sentiment is very close to the top of its range.
While the rebound in stock prices is encouraging some individual investors, others have concerns about its sustainability. Many individual investors are monitoring trade negotiations. Also having an influence are Washington politics (including President Trump and Democratic control of the House of Representatives), corporate earnings, the Federal Reserve, valuations and concerns about the pace of economic growth.
This week’s special question asked AAII members how they view the overall sentiment reflected by the market so far this year. Responses were very mixed. Just under a quarter of all respondents (24%) describe investors as being either cautious or uncertain. Many of these respondents point to the unknown outcomes of trade negotiations as well as the political backdrop in Washington. Nearly 13% of respondents view sentiment as either being optimistic or somewhat optimistic. Almost 10% say investors are too pessimistic. About 12% view sentiment as being too optimistic. Conversely, 4% think sentiment is too pessimistic.
Here is a sampling of the responses:
- “I think investors are hopeful but unsure that the market will post gains in 2019.”
- “I see it as cautiously optimistic but believe the U.S. will iron out the trade issues with China and that the market will react favorably.”
- “My opinion is that sentiment still seems a bit dour when it comes to individual and institutional investors.”
- “The market is reflecting uncertainty about the future due to the political environment and slowing global growth.”
- “The rally since Christmas doesn’t appear to consider the high price-earnings (P/E) ratios across most of the market.”
Bullish: 35.1%, down 4.8 points
Neutral: 39.8%, up 2.5 points
Bearish: 25.1%, up 2.3 points
Local Chapter Meetings
February 7, 2019 Some Perspective on Buybacks Given Recent Criticism
January 31, 2019 How to Invest Differently Than a Mutual Fund
January 24, 2019 AAII Members Share Their Memories of John Bogle
January 17, 2019 A Few Personal Thoughts in Remembrance of John Bogle