Clock and Money

Time Diversification of Risk

Clock and Money

Charles D. Ellis said, “The average long-term experience in investing is never surprising, but the short-term experience is always surprising.” 

The three figures below illustrate this famous quote by Ellis, one of the first proponents of indexing. These charts show 50 years of returns of five different index portfolios in monthly, quarterly and annual periods, and will help investors better understand the time element of riskese. Portfolio 5 is the least risky portfolio, moving up to Portfolio 100 as the most risky. Does time reduce risk? For many years, this question has generated a hot debate among academic researchers and investment professionals. Historical returns have shown that time does reduce risk. 

As the investment time horizon lengthens, the actual average annual compound return achieved by a stock portfolio converges to its expected returns. As the period of measurement changes from monthly to quarterly to annual, the volatility of returns reduces, and the existence of a losing period diminishes.



James K. Glassman summarizes the investor’s dilemma: “In the stock market (as in much of life), the beginning of wisdom is admitting your own ignorance. One of the many things you cannot know about stocks is exactly when they will [go] up or go down. Over periods of days, weeks and months, no one has any idea what [stocks] will do. Still, nearly all investors think they are smart enough to divine such short-term movements. This hubris frequently gets them into trouble.” The dynamic chart below shows while the daily movement is essentially a flip of a coin, longer term movement is predictably positive, as Charles Ellis implied.

Is there predictability of the daily split between gains and losses as compared to the annual return or the years? Not enough to bet on it. See both figures below.