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February 17, 2019

Your Returns May Be Anything but Average

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 Week Ahead
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.
Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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