Don’t Miss the Horizon for the (Choppy) Seas

Over the past few decades, investing has become increasingly democratized. You can trade stocks, bonds, currencies and more with a keystroke. Trading costs are a fraction of what they were in the 1950s, 1960s or 1970s. Information is near constantly available on cable television networks that seem dedicated to bringing you the next big stock market “play.” The Internet is chock full of investing ideas. With all that, you might think it’s easier than ever to invest! But those are mere tactical issues—the “how” of investing. Well before most investors decide whether to pull the trigger on a trade, they’ve already made grave errors such tactics are unlikely to overcome.

One manifestation of this is the proper consideration and inclusion of time horizon in determining the appropriate asset allocation—the mix of stocks, bonds, cash and other securities employed. Many studies have shown the lion’s share of long-term portfolio return ties back to this very decision. An oversight here can mean an investor literally has very low chances of reaching their long-term goals and objectives, almost entirely regardless of what they invest in.

First things first—what do I mean by “time horizon”? Many in the financial industry think of it as the time until some milestone is reached—whether retirement, a major purchase (like college tuition, a house, etc.) or some other life event. And that’s sometimes the case! For example, if the entirety of an investment portfolio is destined to become a down payment on a home, then indeed the time horizon for those assets is most likely the intended purchase date.

But for many investors, time horizon ought to be considered the total amount of time a particular pool of assets needs to work. Consider retirement: If anything, retirement is much more the beginning of the time horizon than its end. Investors are often significantly more dependent on their money’s working for them in retirement than they are prior—after all, their major earning years are typically behind them, and from that point forward, they’re dependent (whether partially or fully) on their nest egg to replace those lost earnings. If investors see their retirement date as the conclusion of their investing time horizon, they may substantially diminish the chances their portfolio lasts through their entire retirement.

For many investors, life expectancy is a common time horizon—the account holder’s (or holders’) life expectancy, possibly, or the life expectancy of those expected to inherit the assets. Meaning retired investors might oversee a portfolio that has a 50- to 60-year time horizon—maybe even longer!

Which leads to another important aspect of time horizon: Not only do many investors define their time horizon incorrectly, they also tend to underestimate it—failing to consider the tremendous medical advances we’ve seen over the last century-plus. (For much more detail on this aspect of time horizon, please see Todd Bliman’s excellent recent column.)

So what’s the problem with these errors? Well, if investors underestimate their time horizon for whatever reason, they’re (by definition) focusing on a shorter period of time over which they want their assets to work—which in turn typically focuses them too narrowly on volatility. Over shorter time periods, stocks are certainly more volatile than bonds—so if you’re focusing on a relatively short window for generating whatever level of growth you’re targeting, you’re probably relatively concerned about volatility and how it might impact your returns (and you likely should be).

However, as your time horizon increases, something interesting happens: The volatility of stocks drops dramatically. You read that right: Equity market returns become decreasingly volatile over longer time periods. (Exhibit 1)

Exhibit 1: S&P 500 Stock Index / US 10-Year Government Bond Index

Source: Global Financial Data, Inc.; as of 01/28/2013.ⁱ

The problem, though, is many investors who focus on too narrow a time horizon and therefore too much on volatility may be tempted—and readily aided by their willing brokers; more on that in a moment—to overload their portfolios on fixed income.

But the flipside of volatility is return—there’s an inherent trade-off between the two. In exchange for only slightly less volatility in a fixed income portfolio over a long enough time period, investors sacrifice significantly higher return potential. If the time horizon is long enough, this sacrifice can have significant implications for the chances investors reach their long-term goals and objectives. Exhibit 2 illustrates why—as you can see, over 20-year rolling time horizons, stocks beat bonds the vast majority of the time. By a wide margin. Over-allocating to fixed income when you have a long enough time horizon can seriously eat away at your chances of even getting long-term, average market returns, let alone something slightly better than that.

Exhibit 2: Rolling 20-Year Stock Versus Bond Returns

Source: Global Financial Data, Inc., as of 1/15/2013.ⁱⁱ Stocks as measured by the S&P 500 Total Return Index; bonds as measured by 10-Year Government Bond total returns.

So properly identifying time horizon is clearly a critical component of any well-constructed investing strategy.

But to be successful, you still have to successfully buck your own hard-wiring urging you to focus on the wrong things. Volatility is one. The near-ubiquitous focus in the media on hot stock XYZ or less-hot ABC isn’t very relevant. What about the hot trend they just highlighted on today’s edition of Shiny Investing Object! What about the charts you saw online? Or that article highlighting the economic trend everyone’s atwitter about? Or that IPO. Or ... or ... or!

And it isn’t only the media. If the financial professional or online service you’ve tapped for help hears you want fixed income added to your portfolio to dampen some volatility, a broker or service paid to trade might just be more than happy to accommodate. (Same with reallocating to more equities when you’re feeling especially bullish.)

But making those shifts sans any consideration of factors like time horizon (among others) is ignoring a big question: Are you even on the right track to get to your goals? What if your path requires more stocks than bonds? How does periodically loading up on fixed income help accomplish that? In short, if you’re hiring someone to help you with your investing decisions, it’s critical you select an adviser incentivized to put investors’ interests first—meaning they’re likely not compensated per transaction (among other indicators), and they’re not getting caught in the trend du jour.

Investing has become far more democratized than it was in prior decades—but democratic isn’t synonymous with “easier.” Perhaps HL Mencken put it best: “Democracy is the theory that the common people know what they want, and deserve to get it good and hard.”

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^I Average rate of return from 1926 through 12/31/12. Equity return based on Global Financial Data, Inc.'s S&P 500 Total Return Index. The S&P 500 Total Return Index is based upon GFD calculations of total returns before 1971. These are estimates by GFD to calculate the values of the S&P Composite before 1971 and are not official values. GFD used data from the Cowles Commission and from S&P itself to calculate total returns for the S&P Composite using the S&P Composite Price Index and dividend yields through 1970, official monthly numbers from 1971 to 1987 and official daily data from 1988 on. Fixed Income return based on Global Financial Data, Inc.'s USA 10-year Government Bond Index.

ⁱⁱAverage rate of return from 1926 through 12/31/12. Equity return based on Global Financial Data, Inc.'s S&P 500 Total Return Index. The S&P 500 Total Return Index is based upon GFD calculations of total returns before 1971. These are estimates by GFD to calculate the values of the S&P Composite before 1971 and are not official values. GFD used data from the Cowles Commission and from S&P itself to calculate total returns for the S&P Composite using the S&P Composite Price Index and dividend yields through 1970, official monthly numbers from 1971 to 1987 and official daily data from 1988 on. Fixed Income return based on Global Financial Data, Inc.'s USA 10-year Government Bond Index.