Best Asset Mix Depends on Your Time Horizon

“Time in the market is more important than timing the market.”
– Unknown

Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.

 

One of the key decisions investors must make is choosing their “Asset Mix”: the percentage of investment assets they hold in the major “asset classes” – Equities and Fixed Income.  For most people, this decision will have the greatest impact on their portfolio’s return… and its risk (or volatility).

Conventional wisdom holds that equities are “riskier” than fixed income investments and that the more equities you hold, the riskier your portfolio becomes.  However, conventional wisdom fails to take into account some key real world factors: the impact of inflation and your investment time horizon.  Let’s take a look at this and then see how we can invest better!

 

Volatility of Stocks where Investor Time Horizon Increases

Chart 1 below shows the annual total return, after-inflation, for a U.S. Large Company Stock Index from 1926 to 2015.  Notice that there are several periods where the real returns are negative.

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Now let’s increase the holding period (Chart 2 for 5 year holding period; Chart 3 for 10 year holding period and Chart 4 for 15 year holding period) and observe the drop in the number of negative holding periods.

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For those math people out there who want to see numbers, Chart 5 summarizes Charts 1 through 4 by showing the percentage of holding periods where the returns were negative.

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So if we hold the U.S. Large Company Stock Index, 31.1% of the time, we would have lost money over a 1 year holding period.  But if our holding period increases to 20 years, we would not have lost money!  One conclusion we can draw from this is that if we are going to invest in U.S. Large Company Stock Index and we don’t want to lose money, our holding period should be at least 20 years.

The implication then might be for holding periods less than 20 years, if we don’t want to lose money, you might think that we should then hold 100% in Fixed Income.  So let’s look at the percentage of down years for 100% in Fixed Income:

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To me, this was the stunning chart.  What this tells us is that when we take inflation into account or rises in interest rates, we’ll lose purchasing power of our Fixed Income investment about 30% of the time regardless of how long we hold bonds.

I thought maybe having 60% U.S. Long Term Corporate Bonds (and 40% U.S. Government TBills) was skewing the results.  So I then tried different combinations of U.S. Government Long Term, Intermediate Term and TBills and found the percentage of down years didn’t improve.

I felt why should we invest in bonds at all when they are so risky?  It took me some time to figure out how to deal with this issue.

I focused on the nature of bonds being loans for a fixed return over a fixed time period.  I like fixed returns, but we need to reduce risk for inflation or rising interest rates.  So to reduce those risks, we might need to add some amount in stocks.  And as the time horizon increases, those risks are greater, so we might have to add a greater amount in stocks.

 

Minimum Risk

To help address how much should be in stocks for a particular holding period, I had to consider how bad can a return be?  And if we knew that the worst could happen, let’s choose the asset mix between stocks and bonds that gives us the greatest of the “Worst Returns”.

I also acknowledged that the absolute worst return could be an outlier result that might not be likely to repeat.  So I defined the average of the worst 5 returns as the “Worst Return”.

Table 1 is a simplified summary that looks at asset mixes from 0% equities to 100% equities at 10% increments for different holding periods (1 year, 3 years, 5 years, 10 years, 20 years and 30 years).  I’ve highlighted in yellow the asset mix that gives us the highest of the Worst Returns for each holding period.

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So, with this table, it suggests that for cash needs one year from now, 100% should be invested in Fixed Income.  For needs that are 5 years away, we should invest 30% in Equities and 70% in Fixed Income.  Ok, but does this help really produce the results of reducing risk or improving returns?

 

Minimum Risk and Average Returns Through Time

Table 2 and its summarized graphs shows for each holding period the Minimum Risk Equity Percentage, the Worst Returns for 100% Bonds, 100% Stocks and Minimum Risk Returns under both the Worst Returns and Under the Average Returns scenarios.

Under the Worst Returns scenario, for each holding period, we find that the Minimum Risk Equity Percent gives the highest returns.

Under the Average Returns scenario, for each holding period, we find that for holding periods less than 14 years, the Minimum Risk Percentage gives better returns than 100% Bonds.  For Years 15 and higher the Minimum Risk Percentage is 100% equities.

In conclusion, Minimum Risk percentages for each holding period gives us better returns than bonds and does so with less risk.

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How to Apply the Results

To experience the results, we need to figure out your cash needs through time.  Then for each need, we discount that amount to today and invest that amount to grow to meet that need.  Of that amount, we invest the Minimum Risk Percentage for that holding period in stocks.

Table 3 below shows how much, per $100 of future need at a particular time in the future, we have to invest today and of that amount how much in equities.

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The Next Step

A knowledgeable investment advisor who spends time to determine your cash needs through your lifetime is able to calculate your percentage of your portfolio that should be invested in Stocks – like the S&P 500 Index to achieve a portfolio that gives you good returns with less risk.

In other words, you should have a custom tailored portfolio as your needs through time and your risk tolerance is unique to you.  You shouldn’t be pigeonholed into one of a small number of pooled portfolio profiles!  You can do better than that.

If you are interested in working with an investment adviser that can help you find the right asset mix that’s geared toward the returns you need and do so with a level of risk that you may be able to tolerate, please call me, Steve Nyvik, at (604) 288-2083 Extension 2 or email me at: Steve@lycosasset.com.