Can A Longer Investment Horizon Make You A Winner?

Can A Longer Investment Horizon Make You A Winner?
Stéphane Renevier, CFA

over 1 year ago6 mins

  • A longer horizon can be your friend: it reduces your risk of loss, makes it more likely you’ll harvest the “average return”, and even enables you to profit from investors’ mood swings.

  • But it won’t solve all your problems: it raises the risk of a large loss along the way and it goes against all your instincts. Plus, there’s the possibility the future will look very different from the past.

  • The longer your time horizon, the less important short-term factors become. So you might want to start scooping up some assets as their prices fall.

A longer horizon can be your friend: it reduces your risk of loss, makes it more likely you’ll harvest the “average return”, and even enables you to profit from investors’ mood swings.

But it won’t solve all your problems: it raises the risk of a large loss along the way and it goes against all your instincts. Plus, there’s the possibility the future will look very different from the past.

The longer your time horizon, the less important short-term factors become. So you might want to start scooping up some assets as their prices fall.

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Long-term investors can seem pretty smug at times. They know they can benefit from opportunities that short-term investors can’t – and they get to shrug off some of the day-to-day price swings that can tie a short-term investor in knots. But that doesn’t mean a long-term approach is without its drawbacks. So, let’s talk about the pros and cons of taking the long view…

What’s the appeal of a long time horizon?

You’re less likely to end up losing money.

Invest in the S&P 500 for a day, and your chances of making money are barely higher than flipping a coin. But invest for five years, and your chances of earning a return go to 90% (if history’s any guide).

The risk of a loss decreases with your time horizon. Source: BofA.
The risk of a loss decreases with your time horizon. Source: BofA.

To understand why, imagine you’re a casino owner. Every time a client plays a color at the roulette table, she’s got a 47% chance of winning. If she plays only once, this isn’t an overly attractive business for you. But if she plays a thousand times, those seemingly small odds you have in your favor virtually guarantee you a nice profit.

Investing is similar. People put their money down only if they see the potential gains more than compensating for the risks – in other words, if the odds are slightly tilted in their favor. Otherwise, they could just put their money in cash (or government bonds) and earn a risk-free return. But, as in roulette, uncertainty plays a role in the short-term for investors, and they could lose it all over a string of bad results. That risk is why investors require a positive expected return – a “risk premium” – and largely explains why stocks tend to grind higher over time. And if stocks drift higher over time but have an element of unpredictability associated with their short-term performance, then a longer investment horizon means that you have more time to recover from losing periods.

You’re more likely to pocket the average long-term return.

Whether you’re investing for one year, or 100 years, the median annualized return you can expect to make is broadly similar: between 5% and 7% in real terms for US stocks, according to Credit Suisse calculations (dark green line). What changes is the deviation around that (green bands): while your annualized returns can vary wildly around that median if you’ve got a short time horizon, they’re likely to get a lot closer to that green line if you hold them for longer.

Annualized real US equity returns for different holding periods. Source: Credit Suisse.
Annualized real US equity returns for different holding periods. Source: Credit Suisse.

The longer your time horizon, the less likely your returns will be influenced by factors like investor sentiment, economic changes, or sheer luck, and the more likely you’ll realize that average long-term risk premium you can expect for holding risky stocks. That’s the secret to achieving exceptional wealth: compounding this average long-term risk premium over many years.

There’s another important takeaway from this: since you’re more likely to harvest that average risk premium, you can buy assets that are riskier or less liquid, and earn an even higher risk premium. This is precisely why private equity and infrastructure assets are so popular with institutional investors who have a very long time horizon.

You can even profit from “Mr. Market’s” mood swings

A longer horizon allows you to capitalize on moments when investors’ indiscriminate selling pushes prices well below their fundamental value. Remember, while prices can deviate significantly from their fair value in the short-term – making valuation a poor predictor of short-term returns – they tend to eventually return to fair value, which makes those levels an extremely valuable tool for long-term investors.

Buying when stocks are cheap (i.e. when the Shiller price-to-earnings ratio is low) can boost your 10-year returns. Source: advisorperspective.com.
Buying when stocks are cheap (i.e. when the Shiller price-to-earnings ratio is low) can boost your 10-year returns. Source: advisorperspective.com.

So what’s the downside of a long time horizon?

A longer horizon doesn’t make your investment risk-free: in fact, it makes a bigger loss more likely.

Sure, you’re less likely to end up with a loss if you’ve got a longer time horizon. But the probability of suffering a massive loss also rises. Look at it this way: if stocks have a non-negative chance of falling 10% in any given month, your maximum loss after one month is only 10%. But you could lose it all after ten months. What’s more, the probability of making a massive loss along the way – say stocks falling 80% from their previous highs – increases too. So the longer your investment horizon, the more likely you’ll be invested when extreme market scenarios play out.

The (long-term) future might look very different from the past.

A longer time horizon might shrink the probability that you’ll lose money, but it doesn’t erase it altogether. For instance, while US stocks have been the best-performing asset over the past few decades, plenty of other stock markets saw decades without a gain. Investors in Japanese stocks waited 51 years to make a positive return, and the same thing could happen to US stock investors in the future. Now, a half-century is an awfully long time to wait for a profit, even for long-term investors. What’s more, the probability that the future is different from the past increases with time, as more unexpected scenarios can break old relationships and change the game.

Annualized real Japanese equity returns for different holding periods. Source: Credit Suisse.
Annualized real Japanese equity returns for different holding periods. Source: Credit Suisse.

Long-term investing goes against all your natural instincts.

Holding stocks for the long term means that you’ll need the patience to do nothing most of the time, the nerves to avoid going all in when your friends make thousands selling monkey pictures, and the discipline to trust in your strategy when everything is going against you. The issue is, we humans are wired to do the exact opposite. Long-term investing sounds great in theory, but it’s certainly not easy to apply in practice.

So, what’s the opportunity?

Almost all assets are down this year and there’s a fair chance they go even lower. For traders and investors with a short-term horizon, holding a significant amount of cash in anticipation of further losses might be as good a strategy as any. But timing market bottoms is incredibly difficult, and their returns will be driven by whether they’re right or wrong.

For investors with a long-term horizon and a more passive approach, investing doesn’t have to be that complicated. As we showed, their returns depend less on short-term drivers (like what the Fed will do or whether they buy at the bottom), and more on what long-term risk premium they are likely to harvest over the long term. For them, time in the market matters a lot more than timing the market.

Mind you, that doesn’t mean buying and holding for a few years will guarantee you positive returns. But if your horizon is long enough, I’d say the odds are in your favor if you were to invest in international stocks, value stocks, or even foreign currencies (versus the dollar).

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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