Time diversification: Does time decrease the riskiness of stocks?

Investing in stocks is risky.  But does equity risk decrease as your timeframe increases?

Yes.  or No.  Depending on how you define risk.

"In the end, the time diversification debate can be restated as a debate over opposing views of risk. Supporters of the time diversification perspective perceive risk as the chance that an equity portfolio will underperform a low-risk portfoli

The historic record suggests that such risk declines with time. Critics of time diversification perceive risk as variations in the final wealth value of a portfolio and uncertainty about the returns investors will experience during specific time periods.

The historic record suggests that the range of such outcomes, from best to worse, widens with time."

Read the entire Vanguard article, Equity risk and time:  A survey of U.S. investors.

The bottom line is that investors need to view equity risk in light of both of the above definitions.  An appropriately balanced portfolio that includes stocks, bonds, and cash is the most sensible way to protect against both market volatility (or "sequence risk"), and inflation.

 

At least it's not 1966 (as far as we know)

1966 was an infamous year in investment history.


For any retirement period duration from ten to fourty-four years commencing that year, 1966 produced the dubious distinction of the worst possible retirement year in recorded market history (going back to 1926).
 
Worse even than any year prior to, or during, the great depression.
 
The combination of brutally high inflation throughout the entire decade of the 1970's and early 1980's and an abysmal bear market during 1973 and 1974 (with a subsequent excruciatingly slow recovery) produced the ultimate portfolio stress test.
 
Two takeaways, one fairly obvious, and one more subtle:
 
1)  If you want a historical "worst case" scenario to stress test a portfolio, start with 1966.  Sure, the future could hold something worse, but if your portfolio can sustain you to a ripe old age under the worst that history has served up (so far anyway), you're probably in a pretty good place.
 
2)  Think back to the environment on the eve of 1966.  The country had begun to heal from losing President Kennedy to an assassin's bullet.  The Cuban Missile Crisis had been averted and the backyard bomb shelter building craze had come to an end. 
 
The United States' ground participation in the Vietnam war had begun only nine months earlier and had not yet turned into the quagmire it would eventually become (public opinion hit its high point in support of the war in March of 1966).
 
The stock market was coming off of three consecutive double-digit gain years.
 
Inflation had run under 2% for the prior eight years.  Interest rates had been at historical lows for nearly a decade.
 
In short, there was nothing that might have indicated that 1966 would commence such a bad retirement investment climate.  To the contrary, things looked pretty good.

 

Beating the market is the ultimate red queen's race

"Beating the market" is called a loser's game for good reason. 

It's worse than casino gambling because: 

1) Upward bias. Casinos mercifully kill off losers because they run out of money. The upward bias of the markets allows most losers to continue playing the game, blissfully unaware of their underperformance. 

2) High costs. The trading, management, and tax costs of active management make the casino's juice downright cheap in comparison. 

3) The rules change. Financial markets exhibit dynamic, not deterministic behavior. Casino games, while the odds are against the player, at least the rules don't change.  Players can confidently make their moves in the context of pre-determined probability and odds. Financial markets are "self-correcting;" what worked yesterday won't work tomorrow. 

Red_queen_logo1

It's the ultimate red queen's race. No professional chess player would play an opponent, either professional or novice, if the audience (the market consensus) could change the rules at will. 

The truly "professional" investor chooses not to play the game at all.

My ipod is possessed... and nobody else has my birthday!

Tales of possessed ipods, supposedly shuffling "non-random" series of songs are all over the internet.

Nano

These complaints are probably being lodged by investment portfolio managers who swear that stock prices aren't random.
Ipod song order and stock price behavior are both random (in the latter case I use the word random to mean "not predictable", not necessarily "without cause.")
 
Our brains are hard-wired to see patterns where none exist.
 
Take this real-world example:  If 23 people are in a room, what is the likelihood that at least one pair has the same birthday?  What about 57 people?
 
For the answer, go here.
 

Discerning skill from luck: I hope you have some time on your hands

Statisticians (and college freshmen) use a "t" statistic to determine the "statistical significance" of an outcome.

The same statistic can be used to tell if an investment's track record is attributable to skill instead of merely luck.

After some algebra, the formula looks like this:

N = (t x sd/mean)^2

N = number of sample data points
t = t statistic; 2.0 is considered statistically significant
sd = standard deviation
mean = average of what you are measuring

Let's assume we have an investment that has generated an eye-popping 5% alpha (excess return) with a standard deviation of 20%
(the average standard deviation of the market from 1926 through 2008).

How long would the manager have to generate this type of track record to be reasonably sure that it was the product of skill and not luck?

N = (2 * 20/5)^2 = 64

64 years.

If the excess return is 4% (still unheard of), N increases to 100 years.
If the standard deviation is 30% (reasonable given the high returns), N increases to 144 years.

Hence the required regulatory disclosure included (usually in micro-print) in every brokerage statement:

"Past performance is no indication of future results."