Do stocks get less risky with time? That’s actually an interesting question and the answer, as with most things, is “it depends.” For most of our investing lives, it’s been beat into our head by the more responsible financial gurus that stocks are for the long term. That is, if you value your wealth you don’t buy a stock hoping it will go up tomorrow. Rather, you buy a broadly diversified portfolio of stocks and hold them for years if not decades. Over 20 years, we’re told, the stock market has never lost value. This is true. But does that necessarily mean stocks become less risky with time?
Not According To Modern Portfolio Theory
It is absolutely true that stocks become less risky in an absolute sense. That is, you probably aren’t going to lose money in the market over a 20 year period in nominal terms. Your account balance will at least be larger than it was at the start. That’s a good thing and for most people, that’s probably good enough. They, quite rationally, look at risk as the chance of permanent loss.
But modern portfolio theory measures risk differently. To the portfolio manager, risk is simply the degree to which returns differ at the end of any given period i.e. risk is volatility of returns. In portfolio theory parlance, this is measured by standard deviation. If returns are more or less normally distributed, there is approximately a 66% chance that next year’s result will fall within one standard deviation of the average return (arithmetic mean, in this case) and a 95% chance it will fall within two standard deviations of the average.
For a real world example, take Vanguard’s Total Stock Market Index Fund (VTSMX). Over the past few years, it’s had a mean return of 8.6 %and a standard deviation of 9.15% which means there is about a 66% chance next year’s return will be between -0.55% and 17.75% and a 95% chance next year’s return will be between -9.7% and 26.9%. Not bad odds. What this means for long-term investors, though, is that due to the long-term affects of compounded returns, the variability of outcomes can be monumental. Over 40 years, $10,000 will turn into $361,100 at 9% per year but over $537,000 at 10% per year, a difference of almost 49%! And that’s only a 1% per year difference. Run the numbers with 2 or 3% and the differences are truly mind-boggling. From a portfolio perspective, the volatility and thus risk of these returns are very high so in a very real way, time actually INCREASES the risks of the stock market. The real-world takeaway from all this is that investment costs matter! Even differences of as little as 0.5% per year can have a dramatic impact on the value of your portfolio at retirement. If you don’t believe me, run the numbers yourself.
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3 responses so far ↓
1 Investment Costs Matter | Amateur Asset Allocator // Jun 30, 2008 at 7:09 am
[...] week, I wrote that from a modern portfolio theory perspective, stocks actually become more risky with time (Obi-Wan Kenobi was right). Because even small differences in returns can have monumental [...]
2 Rob Bennett // Jul 1, 2008 at 5:38 pm
My view is that the riskiness of stocks always depends on the valuation level that applies on the day the stocks are purchased. So stocks bought today (when prices are sky-high) are a lot more risky than the number above (which do not include an adjustment for today’s valuations) suggest.
However, the historical data indicates that that risk does diminish over time. Stocks purchased at today’s prices may well provide a poor return for 10 years or even 20 years. After 30 years, however, even stocks purchased at high prices should provide good returns.
Rob
3 Credit Card Brains » Carnival of Personal Finance #161: The “Feeling Renewed” Edition // Jul 15, 2008 at 12:50 pm
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