When it comes to investing, most of us know that risk fundamentally shapes which investment options we should consider and frames our potential return profile. But how many truly understand the impact of time — or, more specifically, time horizon?
In truth, investing strategies should reflect both aspects: Our preference for or against risk-taking and how long our investments will be allowed to work for us before being liquidated and eventually spent.
Pink Floyd famously sang about the mindset of youth in the song “Time,” noting how we act as if “there is time to kill today” only to suddenly realize “you missed the starting gun.”
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The reason time horizon plays such a critical role in investing is because, as risk grows, most investments tend to become more volatile, meaning their return profiles are more dispersed or scattered widely around the average.
The S&P 500, for example, has returned about 10% annualized on average over the past five decades. But it’s rare to see a calendar year return near 10%, which has happened only once over that 50-year period — in 1993 (+10.08% return).
That’s because the standard deviation, a measure of volatility, is between 15% and 20% for the S&P 500 index. Meaning, in actuality, annual returns tend to be scattered all over the place, with an upward trajectory of +10%, but year-in, year-out returns aren’t all that close to the average, or mean.
Sequential-year S&P 500 returns starting in 2000 were -9.1%, -11.9%, -22.1%, +28.7%, +10.9%, +4.9%, +15.8%, +5.5%, -37.0%, +26.5% and +15.1%. Knowing that, an investor saving for a down payment on a house in three to five years might be scratching their head right now.
Because if she invested $5,000 per year into an S&P 500 index fund beginning in 2000, by the end of year 2002, she’d have only $10,446 of the $15,000 she put aside to save for that down payment. But if she invested the same $5,000 per year starting in 2003, by EOY 2005, she’d have $18,546.
Clearly, for a short-term need like saving for a down payment, investing into the stock market may not be a good idea. The volatility is just too high for that time horizon, making stocks too risky in this situation.
But what about a 30-year-old nurse or electrician or a CPA saving for their retirement in 35 years or so? For long-term time horizons, such as multiple decades, investing into risk assets such as stocks may make sense, despite stocks’ inherent high volatility.
By looking at a rolling 10-year returns for the S&P 500, we find that it’s very rare for any 10-year period to have a negative average annual return.
Over the past 100 years, for example, that’s happened only a few times, especially when investors reinvest dividends back into shares of the S&P 500 index fund. A couple of 10-year periods starting in the late 1920s provided negative average annual returns because those years began with the market crash of 1929 and extended through the Great Depression.
More recently, the 10-year period covering the 2000-2002 and 2008-2009 dot-com bubble and global financial crisis, respectively, had a negative return, even with dividends being reinvested (barely, at -0.95% per year).
Many investors have gotten themselves into trouble by not understanding the connection between time horizon and investment return. It’s easy to visualize, and compute, our money growing uniformly by 10% annually over the next three years, or eight years, or 25 years.
But that’s not how stock markets work. It’s much messier and lumpier than that, and ignoring this fact can do real harm to portfolios.
One tool I find valuable is a simple time vs risk matrix separated into four quadrants, as shown below.
(Image credit: Scott McClatchey)
Younger investors have longer time horizons, so they can invest more aggressively early in their working lives to (hopefully) achieve higher returns.
Historically, as long as this investor held their investments for 20 or more years, they would have been rewarded by stock market returns averaging around 10% annually.
Conversely, for near-retirees or those saving for short-term needs, given their shorter time horizon, they would be wise to keep their investment-risk level or volatility relatively low, to avoid the potential sequence of returns problems we demonstrated earlier.
Hopefully, this short article has persuaded you to carefully consider your time horizon before deciding which investments to purchase in your portfolio.
Past performance is not indicative nor a guarantee of future results.
