The article was first posted on March 1, 2001.
With the current downturn in the stock market, we're starting to see more and more articles in the press extolling the virtues of "diversification", "non-correlated asset classes", and my personal favorite "cash is king". Few people are worried about volatility on the way up, but many get dispeptic on the way down.
Unfortunatey, most of these discussions ignore the most important factor -- the length of the holding (accumulation) period. For buy and hold investors, the longer the money remains invested, the less effect volatility has on the ending portfolio balance. Table 1. compares the terminal value for an S&P500 index fund vs. a stock/cash mix invested at the efficient frontier for the length of the holding period in question. A $2,000 per year contribution was selected to model the accumulation behavior of a typical individual saving for retirement. The "efficient frontier" is the mix of stock and cash that produces the smallest standard deviation (i.e., the least volatility.) It matches the allocations that provide the maximum "100% safe" inflation-adjusted withdrawal rate outlined in the Retire Early Study on Safe Wthdrawal Rates. You can run some of these scenarios yourself on the Retire Early Safe Contribution Calculator, click here.
Table 1. shows the distribution of ending account values (i.e. the "terminal value") for all holding periods between the years 1871 and 2000. For example, there were 100 overlapping 30-Year holding periods between 1871 and 2000. (The study examined 1871-1901, 1872-1902, 1873-1903, ... 1970-2000, 100 periods in all.) The highest terminal value observed for an S&P500 index fund was $903,985. The lowest value observed was $121,370. Listing all 100 terminal values from best to worst, we find that number 50 on the list (the median value) had a terminal value of $248,855.
Table 2. summarizes the results for these comparisons. Once you reach a 30-Year holding period, there is almost no chance the terminal value of the portfolio will be improved by maintaining an allocation to cash.
Holding a well diversified portfolio does indeed reduce the volatility of a portfolio, but may not increase the ending portfolio balance. Investors must pay for this smoother ride by accepting lower long term returns. While psychologicaly difficult for most people to do, ignoring the ups and downs of the stock market and holding a 100% stock portfolio provides the highest returns for 30-year holding periods and longer. It's also much less work. Unlike the corporate world where people that look busy are frequently rewarded for doing the wrong thing, investing rewards the quality of one's decisions rather than the quantity of activity. That's why Warren Buffett says "We make more money while snoozing."
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Copyright © 2000 John P. Greaney, All rights reserved.