The Investment Scientist

Does stock market risk decrease over time?

Posted on: April 27, 2010

[Guest post by Mike Piper] Conventional investing wisdom states that the risk of holding stocks decreases as the length of the holding period increases. But is that true?

The answer depends primarily upon how you define “risk.”

Decreasing Risk Over Time

If you define risk as “chance of losing money,” then yes, stocks have historically become less risky the longer the holding period:

Similarly, if you define risk as “chance of underperforming cash or Treasury Bonds,” then yes, stocks have historically become less risky the longer the holding period:

And if you define risk as “range (or standard deviation) of annualized real returns,” then yes, stocks have historically become less risky the longer the holding period:

Increasing Risk Over Time

In my experience, however, many investors conceptualize risk by comparing the best and worst possible outcomes. They ask themselves, “how much money will I have if this goes well, and how much will I have if it goes poorly?”

And when you define risk as the range of total returns (rather than annualized returns), stocks actually become more risky the longer the holding period:

Some people find it surprising that the range of total returns increases over time, despite the fact that the range of annualized returns decreases over time.

For example, if we go back to our third chart and look at 30-year periods, we can see that the worst annualized real return (4.2%) is only 5.66% lower than the best annualized real return (9.86%). The important thing to remember is that, when compounded over 30 years, a 5.66% difference in annual return leads to an enormous difference in ending value.

Does this make stocks a poor choice?

No. (At least, not in my opinion.) Given their tendency to outperform other asset classes over extended periods, stocks still merit inclusion in most long-term portfolios.

It’s important to understand, however, that (when measured in ending value rather than annualized return) stock market performance is unpredictable, even over long periods.

In contrast, there are other categories of investments–TIPS, primarily–that do offer more predictable returns. So if you’re in a situation where predictability is important (such as funding a known expense at a known point in the future), stocks are likely not the best choice.

Important note: All of the above are simply historical observations relating to the U.S. financial markets from 1928-2009. (The S&P 500 was used for stock returns, and 10-year Treasury Bonds were used for bond returns.) While history can be a useful guide, the future will certainly be different from the past–perhaps dramatically so.

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5 Responses to "Does stock market risk decrease over time?"

My home owners association invests our reserve funds in insured CDs or government bonds. The return is lousy, but the principal is guaranteed -or at least it’s as safe as the currency, fwiw. Our time horizon is only 5-10 years for replacing many major pieces of equipment, with some reserve withdrawals made annually. (The HOA is almost 20 years old. Something wears out every year, a point with which I increasingly sympathize.) Your analysis shows why, as fiduciaries for our organization, the Treasurer (me) and the Finance Committee say that we must not invest in stocks or other risky investments. I am going to refer my colleagues on the Board to your entry, since you show this information in a much clearer manner than I ever could. They agree with me on safety, of course, but every so often a homeowner has a “better idea with higher return” for investments. Thank you, Michael, for another good article.
– Jerry

Jerry,

In your HOA situation, the goal is not to grow the money as much as possible, but to match your liabilities as closely as possible. Therefore it is not appropriate to take equity risk. Be careful though not to use long-term CDs or bonds, since they have duration risk which sometimes can be as bad as equity risk.

Michael

you write, “And when you define risk as the range of total returns (rather than annualized returns), stocks actually become more risky the longer the holding period”

You are absolutely correct! This is substantially different that the message the financial media puts out. Substantially different that the message investment companies put out.

If you have non defensive strategy, but just raw, asset allocation, your risk never decreases.

best,
Dave

Anything that calls for a 0% risk your funds will not increase in 25 years tunes me out.

And then when I look again it said a 0% chance that stocks would not beat out bonds over a 25 year period.

Really?
0%
100%

You couldn’t even put in a 1% and 99%?

Nothing in investing is 100% certain.

Frank

Frank,
A little more reading comprehension is in order on your part. The graphs clearly state that these are historical analyses of actual results, not predictions of future returns. Mr. Piper is showing what actually happened in the stock and bond markets over time. If the data have shown these trends, then he must show these numbers, not what makes him (or you) comfortable. Anything else would be a lie. regards,
Jerry

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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