But how quickly do the risks in equity investing diminish over time? Is there some time period after which potential returns from equities outweigh the risk of loss?
Jeremy Siegel, a professor at the Wharton School and author of the popular book Stocks for the Long Run, argues that equities make sense over almost any timeframe, citing the outperformance of equities over bonds based on nearly 200 years of historical data.
Zvi Bodie, a professor at Boston University and an expert on retirement planning, takes the opposite view. Bodie says equities are inherently risky and that risk increases continuously over time. Investors following Bodie's advice would hold substantially all their assets in Treasury Inflation Protected Securities (TIPS).
Let's look at time horizons of ten years or more, as this is the focus of retirement-oriented investors. One way to answer the question is by analyzing the historical drawdowns and rallies for U.S. equity investors over various time periods. Industry consultant Ron Surz provides the following data.
For all-equity portfolios, the worst drawdowns were negative for all ten-year time horizons, but for 20- and 25-year time horizons there were no negative returns (that is, the worst drawdowns were positive outcomes). The best rallies similarly occurred over 20- and 25-year periods, easily outdistancing the best outcomes over shorter time periods.
So, for equities, based on this data investors need to have at least a 10-year horizon--and perhaps as long as a 20-year horizon--in order to be confident of earning a positive inflation-adjusted return and having a chance at far superior returns.
Longer time horizons do not mitigate the risk for all-bond portfolios. For holding periods of five years or longer, the worst drawdown is between 40% and 50%. Since these numbers represent cumulative (un-annualized) returns, the risk is lessened with bond portfolios, but it does not go away. "The tendency to recover from the worst isn't in the bond data," Surz said.
Mark Kritzman, CEO of Cambridge, Mass.-based Windham Capital Management, has written about this topic. Kritzman's data reaffirm Surz's findings and show that end-of-horizon risks to equity portfolios decrease over time. Moreover, the probability of loss at any time during the period stops increasing after 10 years. Kritzman has also shown that the probability of loss within a given time horizon is greater than the probability of loss at the end of the time horizon, correcting a view that risk of loss decreases immediately with increases in the holding period.
Surz and Kritzman therefore agree that stocks become less risky as investors increase their time horizons, and a key transition is between 10 and 20 years, when the probability of inflation-adjusted loss approaches zero, at least based on historical data.
But their views contradict those of Zvi Bodie, who cites the fact that the cost of put options--which protect against the risk of equity investing--increase over time. Therefore, the risk of equity portfolios increases in parallel.
Michael Edesess, a financial advisor trained in advanced mathematics, explained how these views can be reconciled. Surz and Kritzman treat risk as the probability of losing money, but do not incorporate the magnitude of such losses. Bodie's option pricing methodology reflects both the possibility and magnitude of loss, as would a Monte Carlo simulation.
Surz' data reflect 83 years of historical returns--roughly the span of a lifetime. Edesess explained that this is really a fairly small sample size, and stock prices may not conform to theoretical predictions, even if the theory is sound. U.S. equity investors may have benefited from abnormal pleasant tailwinds, as some studies have suggested.
"Investing in the stock market could be quite risky even over 25 years--there's no guarantee," Edesess said. "If one doesn't want to mess with it they should buy TIPS as Bodie suggests--but of course you could expose yourself to an awful lot of regret later if you do that."
Robert Huebscher is founder and CEO of Advisor Perspectives (www.advisorperspectives.com), a Web site and newsletter serving the financial advisory industry.