Time Diversification: A Bizarre Discovery? Not to Us!

Time Diversification: A Bizarre Discovery? Not to Us!

Time Diversification: A Bizarre Discovery? Not to Us!

Time diversification of risk refers to the idea of a risky portfolio becoming less risky when held over a long investment period. For example, for IFA's Index Portfolio 100 on glide path, the range of rolling 12-month returns over the last 50 years spans from -49.4% to 77.4% while the range of rolling 15-year returns spans from 5.7% to 22.8%. Notice that the range of annualized returns is much narrower for the 15-year period than for the 12-month period. However, the opposite is true for the range of ending values. Over the 12-month period of time, a $100,000 investment could have shrunk to as little as $50,600 or grown to as much as $177,400. For the 15-year horizon, the range of ending values spans from $230,300 to $2,172,300. It is this much wider range of possible ending values that prompts some academics to posit that risk actually increases with time. The argument really boils down to how risk is defined.

At Index Fund Advisors, we have extensively analyzed our own data that goes back more than 85 years, and we have concluded that if risk is defined as the probability and magnitude of a risky portfolio losing purchasing power (i.e., having a lower return than the change in the consumer price index over the period), then risk definitely declines over longer holding periods. The theoretical cost of an option to insure that a market-indexed portfolio of equities maintains the exact same purchasing power that it had at the beginning of the period approaches zero as the period lengthens. Of course, such an option is not available in the market, and if it were, it would definitely sell at a higher price than its theoretical value. Some of the academics who have entered this debate have also taken the position that option pricing theory does not refute time diversification. By no means do we claim that time diversification is a free lunch. As the estimable William Bernstein said in The Investor's Manifesto, "The rewards of equity ownership are paid for in the universal currencies of financial risk: stomach acid and sleepless nights."

Recently, we encountered a newly released paper1 that supports our position. The authors analyzed 113 years of historical returns data from 20 countries (over 2,000 years of total return data). As the authors state in the abstract, "We find strong historical evidence to support the notion that a higher allocation to equities is optimal for investors with longer time horizons, and that the time diversification effect is relatively consistent across countries and that it persists for different levels of risk aversion." In an interview with ThinkAdvisor, one of the authors of the study, Michael Finke, said, "The bizarre thing is if you have a 30-year time horizon, equities become less risky in terms of purchasing power than holding 1-year Treasury bills and rolling them over." That is precisely what we concluded, but we did not consider it bizarre but rather simply a reward for bearing risk and postponing consumption for a long period of time. Professor Finke wisely hedges their findings when he says,

"It's not a 100% certain that time diversification is going to work — nobody knows what's going to happen in the future. The best we can do is gather as much data as possible and make forward-looking estimates as to what an optimal portfolio should be based on the most thorough possible analysis of backward-looking data."

We could not agree more.

1Blanchett, David and Finke, Michael S. and Pfau, Wade D., Optimal Portfolios for the Long Run (September 4, 2013). Available at SSRN: http://ssrn.com/abstract=2320828 or http://dx.doi.org/10.2139/ssrn.2320828