How long can you hold?

The Investment Reporter, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

 

How long you invest for-what’s known in the jargon of the investment industry as your ‘time horizon’-is critical to your investment success.

A friend who is 62 says he wants to buy growth stocks for the next two-and-a-half years. Then when he turns 65, he’ll sell the growth stocks and reinvest the proceeds in dividend-paying stocks. The key risk he faces is the possibility that growth stocks will lag income stocks (see the box on this page). However, because he’ll be switching to dividend-paying stocks and will stay invested in stocks for much more than two-and-a-half years, this plan could work out.

We would normally advise against buying stocks for just two-and-a-half years. That’s because stocks can lose money over this fairly short period. A prime example of this was during the financial crisis and the ensuing recession a few years ago. North American share prices plummeted.

With stocks, you can expect average yearly compound returns of 10 per cent or so. This expected return stays the same no matter how long you invest. But the actual returns on your portfolio-above or below this average-depends heavily on how long you invest: the longer you hold your portfolio, the closer your actual results will come to the average.

You earn the average return with time

A study by U.S.-based Cambridge Associates shows this. The study looked at the link between how long you invest and the range of actual returns. The figures come from U.S. stocks from 1901 to 1990. Remember that these returns are what’s known as ‘real’ returns (which remove the impact of inflation). As a result, the average yearly compound returns are below the 10 per cent ‘nominal’ rate of return.

Let’s start with an investment period of one year. The best one-year return on stocks was 53.4 per cent, the worst was negative 37.4 per cent and the average, 8.3 per cent. If you plan to hold stocks for only a year, you had better pick the right year to do so.
When you invest for five years, the range of returns narrows. The best five-year return was 29 per cent, the worst, negative 11.7 per cent and the average, 6.5 per cent. Extend the period to 10 years and the range narrows further. The best 10-year return was 17.9 per cent, the worst, negative 3.9 per cent and the average, 6.1 per cent. That is, the risk from a worst-case outcome is sharply curtailed.

Holding for 20 years or more produced positive returns for stocks. The best return was 13 per cent, the worst, positive 0.8 per cent and the average, 6.2 per cent. In other words, history suggests you’re unlikely to lose money if you hold for at least 20 years.

Finally, holding periods of 25 years came even closer to the average. The best return was 11.5 per cent, the worst, 2.7 per cent and the average, 6.6 per cent (close to the long-run average of 10 per cent when you add back inflation).

The longer you hold a portfolio, the better

In short, the longer you hold a diversified stock portfolio, the more likely you are to earn the expected average yearly compound return. In fact, that’s likely why insurance companies promise to make up any losses on segregated funds held for long periods: they know there’s little chance of a major loss.

Since our friend plans to buy dividend-paying stocks after two-and-a-half years, he’ll invest for much more than two-and-a-half years. This reduces his risk of a loss.

Also, even if his growth stocks go down, it’s likely the income stocks he’ll buy later on will be down too. The key risk he faces is if growth stocks significantly under-perform income stocks. But there’s no knowing which type of stock will lead the market.

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846

 

 

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