Intelligent Design

John McMillen | Portfolio Manager

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Just How Long Does It Take To Get Those Long-Term Returns?

November 2011

One of the most important determinants of an investor’s ability to assume risk is their stated investment time horizon. It is well documented that the longer an investor’s time horizon, the more likely a significant equity allocation may be appropriate. But what, exactly, is “long term”? While the phrase can have different meaning to different investors, it is critical to understand what the phrase means in the capital markets.

To help investors match their time-horizon with the appropriate investment, most practitioners use past history as a guide to the future. To make apt comparisons, we use data from the CRSP 1-10 Index (which is all stocks in the New York Stock Exchange divided by size into 10 deciles). The CRSP Index shows the risk and returns of the entire market, much like a well-diversified portfolio would contain. The data it shows may be surprising to many well-diversified investors, as it seems that “long term” may not be as long as people think.

The graph below highlights this. It shows that, from 1950 to 2011, the equity markets generated a positive return more than 90% of the time for holding periods of four years or longer (green area, left scale). Additionally, for time horizons of 11 years or longer, there was not a single recorded period of loss for stock investors.

The data also shows that, as the investment horizon is extended, the Maximum Annualized Loss decreases rather substantially (red line, right scale). For investors with a one- or two-year investment horizon, losses in excess of 30% have sometimes occurred (as many investors know all too well), but for those with time horizons greater than six years, annualized losses have not only been rare, with 97.9% reported positive outcomes, they have also been relatively small when they do occur. Thus, investors who at the very least want to get back any capital they invest should have a minimum time horizon of six-years – if they are in a well-diversified portfolio. (If not, all bets are off!)
In comparison, fixed-income investors will find a considerably shorter time period is needed to be reasonably assured their wealth will remain intact. As the graph below shows, two-year holding periods generated positive returns more than 98% of the time in the bond market from 1950 to 2011, and after just three years, losses all but disappeared. 

Having examined the likelihood of losses for investors in both stocks and bonds, let’s consider which asset class has the highest returns, and how long it takes to achieve those returns. Not surprisingly, stocks have historically generated higher returns than bonds, but the question is, how long does an investor have to stay invested to capture those higher returns?

The graph below examines this issue. It shows that, from 1950 to 2011, equities generated a higher return than fixed-income 68% of the time in any given one-year time frame (green area, left scale). As the investment horizon is extended, the probability of excess relative performance for stocks compared to bonds steadily increases. Once a time horizon hits approximately 15 years, less than 5% of the observed time periods have seen fixed-income securities outperform equity securities. After 21 years, there was not one occurrence where bond investors generated a higher annualized return than stock investors.

Amazingly, this data captured a 60-year time period which contained five major bear markets for stocks, with average losses in those downturns of 45%. It was also a time which, due to steadily declining interest rates, was very favorable for bonds. And yet any holding period 15 years or longer saw stocks beat bonds 95% of the time, and that percentage climbed to 100% when the holding period went out past 20 years.

The graph also shows that the average difference in performance between stocks and bonds on a year-by-year basis was significant (red line, right scale), with stocks beating bonds by an average of nearly 6%. Even as the time horizon was extended, the excess return earned by equity investors over fixed-income investors averaged almost 4% annually.
Four percent compounded annually over a lifetime will create almost unimaginable differences in terminal wealth. Despite this, even with suitably long investment horizons and the goal of wealth maximization, most investors are underexposed to equities due to their perceived risk. Though greater volatility is almost certain with higher equity exposure, history shows this risk subsides substantially – and ultimately disappears – with the passage of time.

My intention is not to discount the use of bonds; certainly an investor’s willingness and ability to remain fully invested during inevitable periods of high volatility warrants consideration of having bonds in the portfolio. However, for those looking to maximize their wealth there is strong justification to have a significant capital allocation to equities to achieve that goal.

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