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Respect the Time Horizon

Respect the Time Horizon

April 24, 2020
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Respect the Time Horizon

Anyone who has taken a risk tolerance or asset allocation questionnaire has answered a question regarding the time horizon for their investments. Taking time horizon into consideration allows us to have a general sense of how much risk we can take with regard to various savings goals. Time horizons are not fixed by any means; they tend to vary based on the individual and the intended use of the funds in question. When saving for a child’s post-secondary education, the time horizon is pretty easy to define. It is simply the amount of time between now and when they finish high school. When starting to save for retirement, we may not know the specific date we will stop working full-time, but we know that it is a long-term time horizon. 

When investing for any goal, these time horizons have an impact on the level of risk we will assume. With most investments we expect the value to go up over time but due to the volatility of short-term price movements, we are less certain about whether or not they will go up in the immediate future. I can be fairly certain that the S&P 500 index will be higher in 20 years than it is today but I have much less conviction in whether the value next month will be higher than today. If I am beginning to save for retirement and have a long time horizon, I am willing to invest in riskier assets like stocks because even though I have no way of telling whether they will rise or fall in value tomorrow, I also don’t need to spend my retirement savings tomorrow so that uncertainty is tolerable. Now consider shorter-term savings goals such as a down payment for a house. While you may not have a specific date in mind for purchasing a house, you do know that it will be relatively soon and you will have a general idea of how much money you need to get a loan for a house in your price range. With a short-term goal like this, having large price swings like those that stocks can sometimes experience might not be as acceptable. You want to know that the value required for the down payment is readily available when needed so you would invest it much more conservatively than you would when starting to save for retirement.

Behavioral Economics

While these concepts are familiar to most who have experience saving and investing, our behaviors don’t always reflect this fact. An emerging field within economics over the last few decades has started to focus more on the ways that the average individual acts when confronted with decisions such as this. While traditional economics predicts the way that a perfectly rational human being would act given perfect information, behavioral economics focuses on the ways that observed human behavior differs from rational expectations and why. Traditional economics would expect that people would respond with an equal but opposite emotional response to a 10% rise in the value of an investment compared to a 10% drop. Conversely, behavioral economics observes that the pain felt from a loss is twice the pleasure felt from a gain of equal magnitude. This concept, known as prospect theory, is one of the many observations made by Amos Tversky and Daniel Kahneman over their careers and is described in Kahneman’s book Thinking Fast and Slow

Prospect theory is one example of the biases that can exist in the human mind. Their origin is thought to derive from the behaviors our ancestors needed to simply survive but they are no less relevant to modern humans, especially when making financial decisions. In hunter-gatherer societies, food was a scarce resource that ensured survival. Today, money is that scarce resource so it would seem to be a natural reaction for us to worry about our financial future or panic about short-term drops in value. This is where respecting the time horizon comes into the picture.

While choosing a time frame at the outset may be easy and even provide us with a peace of mind that we are putting a plan in place, most people find it difficult at one point or another in the future to actually respect that time frame and the consideration that was put into it initially. One way that this can manifest itself is in checking the value of your investments daily or even multiple times a day, especially with technology that makes this task easier than ever. The table below shows the number of periods that the S&P 500 has risen or fallen when observed daily, monthly, and annually.

As you can see, there is a stark difference in the gain/loss split depending on how often you observe the value. If we looked at the index daily it would seem to be an almost 50/50 split between rising and falling days, but when only observing annually, prices seem to rise almost three times as often. Since we know that we treat losses twice as negatively as similar gains, that 53/47 daily split would weigh much more heavily on our emotional state than the 73/27 annual split. Let’s look at the data again and this time consider the impact when we combine it with the concept of excess negative utility from prospect theory.

In this table, we have added a column titled “Utility” that simply represents the positive or negative sentiment reflected by the percent of rising or falling periods. Since prospect theory dictates that negative outcomes have twice the negative utility as the positive utility derived from positive outcomes, we will assign +1 utility for a rise in the index value and a -2 utility for a fall in the index value. The amount of positive utility minus the amount of negative utility gives us a net number of the sentiment derived from observing price changes on a daily, monthly, or annual time frame. 

While this is a simplistic example that ignores the magnitude of gains or losses, it illustrates the point that more frequent observations can have a negative impact on our sentiment surrounding our investments. If our time horizon is being measured in years or decades, why are we so concerned with daily price changes, especially when the index values we often follow aren’t always reflective of our entire portfolio? (Another topic for another article) If all this did was have a negative impact on our feelings in the short-term, it might be easier to ignore. In reality, these negative emotions tend to lead to actions; actions that are often contradictory to long-term goals.

The Emotional Response to Fear and Greed

Tracking portfolio balances with increased frequency leads to changing investments more often than not, especially during times of increased fear or greed in the stock market. Some people observe large drops and want to make changes, but only for the short-term to sit on the sideline until things calm down. The problem with this is that it converts you from an investor to a market timer which data shows to be ineffective at best [source]. While the idea of sitting out when things get rough may sound appealing, it also requires you to determine when things are no longer “rough”. When is it time to step back in and reinvest your assets? Is it a certain price level? Is it a certain percentage rise from a recent low? How do you know it isn’t just a short-term spike that eventually reverses to new lows? This is only compounded by the fact that stepping aside in the first place turns losses that may only exist on paper into real losses that are reflected in your account balance.

Others see large market swings and realize that their initial portfolio allocation was more aggressive than they could actually stomach. They may decide to make a long-term shift to a more conservative portfolio. (This assumes that the original, riskier portfolio was in fact an appropriate selection and that the change is motivated simply by losses) While this also calms the feelings of anxiety, it nonetheless has implications that may not be immediately apparent. By shifting to a more conservative portfolio, they are also reducing the ability of their portfolio to recover the losses already sustained. More risky portfolios may come with the potential for large and sudden losses but they also provide the opportunity for large and sudden rebounds that a more conservative portfolio may not. Additionally, their shift to a riskier portfolio will impact their ability to meet future financial goals. A later retirement date, lower spending rates in retirement, or fewer assets to pass on to heirs are all possible outcomes as a result.

The Rational Response to Those Emotions

While behavioral economics helps to explain why wanting to make a change is a natural response to have, the hard data shows us that we are often better off in the long-run if we hold steady and maintain the course. When markets sell-off for extended periods of time, we often see the bottom marked by a sharp initial rebound from the lows with large daily percentage gains. Before you think of using this as a timing strategy, consider that in the midst of sell-offs, volatility usually increases to the point where daily moves of 3% or more become commonplace, making temporary bottoms look like actual ones until long after the fact. Missing out on these large daily rebounds from a true bottom can significantly reduce your annualized returns [source]. According to the 2019 J.P. Morgan retirement guide, the annualized return for the S&P 500 from January 3rd, 2000 through December 31st, 2019 was 6.06% if you stayed fully invested for the entire 20 year period. If you missed only the 10 best days OVER 20 YEARS that 6.06% dropped all the way to 2.44%. Make that the 20 best days and you’re down to only 0.08%. It gets worse from there. 

Now that we’ve demonstrated the risk of veering off course, it might help to have an idea of how long it can take for a full recovery. There have been 24 bear markets for the S&P 500 since 1928 [source]. The average time to get back to even from the low point across all instances was 26 months. When looking at historical figures going this far back, I often focus on the post-WWII time frame because of how much change was enacted within the financial system in the wake of the Great Depression [source]. In the period after World War II, the average recovery time from these bear markets has been much less at only 17 months. Of the total count of 24 bear markets, half of them recovered their losses in less than a year.

Another article looks at the same topic but instead of looking for a rebound to a specific price, it focuses on what returns are when you look out from a bottom to specific time intervals in the future [source]. The author looks at time intervals from 3 months up to 20 years against drops ranging from 0-5% through 50%+ from local peaks, all since 1950. On average, returns at all time intervals studied and all ranges of price drops covered were positive after those declines. In the worst scenarios where losses were 50% or more, the average return in the 12 months following was 53.1%. While that wouldn’t recover the entire loss of 50%+, it reiterates the point that rebounds can happen just as swiftly as the losses. Even in the worst recovery period after a loss of 50%, the returns over the following 12 months were 41.6%. More importantly for investors with an intermediate to long-term time horizon (which should be most individuals with significant stock holdings) is the annualized returns over the 3, 10, and 20-year periods following a drop. For drawdowns of greater than 30%, the average annualized return 3 years or more out is always greater than 7.0%. For the 20 years following a drop of 30% or more, the average annualized return is even higher at 9.0%+. That is far greater than the 7.8% annualized since 1950 (or 5.8% since 1927), providing a fantastic buying opportunity for investors with a longer time horizon.

What Happens After the Stock Market Falls?

While it is easy to look back in hindsight and see that asset values have recovered, it is much more stressful when you are in the middle of it. This is why choosing an appropriate time horizon and asset allocation at the outset is so important. By only looking at the potential upside of a portfolio, we are considering less than half (according to prospect theory) of the emotional investment that will be tied up in addition to the assets themselves. Using expected return and standard deviations can help project the rare but inevitable decline in a 5% scenario or 1% scenario and allow you to consider how you would feel about holding that portfolio then.

One of the biggest areas that a financial advisor can add value for their clients is in setting proper expectations for both positive and negative outcomes and sticking to the plan as much as possible. A research paper from Vanguard found that an advisor can add 1-2% or more annually over the life of a relationship by properly allocating assets from the beginning and holding steady [source]. Starting with a proper assessment of needs, establishing goals, and comprehensive risk profiling (something we will dive into further in future posts) as well as maintaining the course and putting things in the proper perspective when the outlook isn’t so rosy all go a long way to achieving good outcomes.

- Adam Blocki, CFA, CFP®

By Adam Blocki, a premier fiduciary institutional RIA asset manager with A Smarter Way to Invest. Adam is our friend, colleague, and a financial strategist. Originally published in Type Two Wealth Blog, this article is reprinted with permission.