Most investors focus on the risk-return properties of their securities or portfolios, but factoring in a third dimension – time – can help you make better investment decisions.
Traditional wisdom dictates that securities and portfolios should be selected or constructed after careful consideration of the risk-return properties of each security, and the portfolio as a whole. This conventional method adopts a two-dimensional approach to assessing assets: the consideration of relative risk and the consideration of relative return. In academic circles this is often referred to as the efficiency frontier.
What I have always found interesting about this approach is, firstly, that there is no consideration of time, and secondly, that risk is always defined as volatility. By virtue of these two seemingly inconspicuous assumptions, it is my belief that investors can be led astray.
Let’s say for example you have 20 years left before retirement. In this scenario your risk is perhaps not short-term volatility, but rather the risk of not saving enough for retirement or outliving your capital during retirement. At this stage of an investor’s life, these are clearly far more serious risks than short-term volatility.
Another interesting observation is that the longer you invest, the closer an asset class tends to move toward its long-term average return. Over the short term, returns can vary greatly, but the more time passes, the narrower the range of outcomes becomes.
Is the asset class then potentially less risky than what is assumed in the traditional efficiency frontier? I would certainly say so. By adding a third dimension, investment horizon, to the two-dimensional approach, we can assess risk more accurately and use asset classes more effectively. By incorporating this third dimension in our assessment or financial plan, we can make better investment decisions.
So how do we use these new investment superpowers to become a better investor? Start with investment horizon, consider how much time you really have, then think about what you deem your risks to be over that period, then stick to your plan. Is losing 30% of your capital over a 12-month period really a risk if you know that over longer periods you will not only recover, but generate superior returns?
Is cash really the lowest risk investment when, although it is highly unlikely that you will lose capital over a 12-month period, we know that the probability of not generating inflation-beating returns is actually the highest of all asset classes over the long term?
It is important to note that if you can reduce risk by extending a time horizon, it implies that you can increase risk by reducing a time horizon. This is again a really important consideration when investing.
The riskiness of an asset class is not the same over all time periods; it changes as the investment horizon is increased or decreased. That also means that if you apply the wrong horizon to an investment, that you could increase the risk. Ultimately, the investor has the power to alter the riskiness of an investment, by extending or reducing the time horizon of their investment. Successful outcomes depend on having a thorough understanding of the time horizon you are investing for, and how this should influence your decisions. A qualified financial adviser can help you factor this into your overall plan effectively.
By Adriaan Pask, CIO at PSG Wealth