Stocks and Time
People say that stocks get less risky the longer you own them.
Stocks are riskier the longer you hold them.
You know: don’t invest money you need soon. But for the money you need in retirement, investing in stocks (low-cost, well-diversified ETFs) makes sense. Eventually, stocks become riskier. You will need to turn assets into income, and you better have some cash ready, or at least some safer assets that are pretty safe. Don’t Sell Low.
Stocks become risky over time because while the probability of losing money might decrease, the amount of money at risk becomes much larger!
Stocks are riskier the longer you hold them. And the longer you hold them, the closer you will need them to fund your retirement. This contradiction is known as the fallacy of time diversification.
Let’s explore time diversification and find ways to get around the fallacy.
Time Diversification and Volatility
The easiest way to avoid a fallacy is to understand that it is both true and not true simultaneously. There are several ways to prove that point.
First, understand your time frame. If you have a short timeframe, cash equivalents are indicated. Buy stocks when you have time on your side.
Next, while the volatility (or distribution) of returns decreases over time, each year has the same actual volatility as every other year. Statistically, you can lose the same percentage in your investment’s lifespan any given year.
The risk of time diversification: you have the most to lose when you also have the most to gain. You don’t want to suffer a huge loss to your portfolio, but what if you need to stay aggressively invested to reach your goals?
Volatility is why time diversification is a fallacy. You have a real risk of pain when the reward is the greatest!
The chance of a loss may be the same every year, but the impact is only huge later.
The Fallacy of Time Diversification
Maybe it’s a fallacy? It is both true and not true. Time massively affects the impact but not the probability.
You have more to lose as the years pass and your assets grow. A 50% loss hurts more in year 29 than year 9.
While stocks seem less risky the longer you hold them, this is only true ON AVERAGE and not when you are close to needing the money. Retirement is turning assets into income. If you’ve got to do that soon, stocks are riskier the longer you hold them.
Stocks are Riskier the Longer you Hold Them
In summary, once you get old, like me, it is useful to consider time diversification. Stocks are riskier the longer you hold them!
The risk of a market drop year over year is the same, and as your assets grow, so does the risk of a major loss. Investing has chapters just like life; you have more to lose the longer you are along your expected time horizon.
Solve the fallacy and understand that the risks to your portfolio change over time and the chapters of your life. When you are young, volatility is not a risk. Volatility matters only when close to retirement (sequence of returns risk).
Stocks are always risky investments, even over the long haul. They don’t get safer the longer you hold them.