One of the most important determinants of an investor’s ability to assume risk is their stated investment time horizon. It is well documented that the longer an investor’s time horizon, the more likely a significant equity allocation may be appropriate. But what, exactly, is “long term”? While the phrase can have different meaning to different investors, it is critical to understand what the phrase means in the capital markets.

To help investors match their time-horizon with the appropriate investment, most practitioners use past history as a guide to the future. To make apt comparisons, we use data from the CRSP 1-10 Index (which is all stocks in the New York Stock Exchange divided by size into 10 deciles). The CRSP Index shows the risk and returns of the entire market, much like a well-diversified portfolio would contain. The data it shows may be surprising to many well-diversified investors, as it seems that “long term” may not be as long as people think.

The graph below highlights this. It shows that, from 1950 to 2011, the equity markets generated a positive return more than 90% of the time for holding periods of four years or longer (green area, left scale). Additionally, for time horizons of 11 years or longer, there was not a single recorded period of loss for stock investors.

The data also shows that, as the investment horizon is extended, the Maximum Annualized Loss decreases rather substantially (red line, right scale). For investors with a one- or two-year investment horizon, losses in excess of 30% have sometimes occurred (as many investors know all too well), but for those with time horizons greater than six years, annualized losses have not only been rare, with 97.9% reported positive outcomes, they have also been relatively small when they do occur. Thus, investors who at the very least want to get back any capital they invest should have a minimum time horizon of six-years – if they are in a well-diversified portfolio. (If not, all bets are off!)
In comparison, fixed-income investors will find a considerably shorter time period is needed to be reasonably assured their wealth will remain intact. As the graph below shows, two-year holding periods generated positive returns more than 98% of the time in the bond market from 1950 to 2011, and after just three years, losses all but disappeared. 

Having examined the likelihood of losses for investors in both stocks and bonds, let’s consider which asset class has the highest returns, and how long it takes to achieve those returns. Not surprisingly, stocks have historically generated higher returns than bonds, but the question is, how long does an investor have to stay invested to capture those higher returns?

The graph below examines this issue. It shows that, from 1950 to 2011, equities generated a higher return than fixed-income 68% of the time in any given one-year time frame (green area, left scale). As the investment horizon is extended, the probability of excess relative performance for stocks compared to bonds steadily increases. Once a time horizon hits approximately 15 years, less than 5% of the observed time periods have seen fixed-income securities outperform equity securities. After 21 years, there was not one occurrence where bond investors generated a higher annualized return than stock investors.

Amazingly, this data captured a 60-year time period which contained five major bear markets for stocks, with average losses in those downturns of 45%. It was also a time which, due to steadily declining interest rates, was very favorable for bonds. And yet any holding period 15 years or longer saw stocks beat bonds 95% of the time, and that percentage climbed to 100% when the holding period went out past 20 years.

The graph also shows that the average difference in performance between stocks and bonds on a year-by-year basis was significant (red line, right scale), with stocks beating bonds by an average of nearly 6%. Even as the time horizon was extended, the excess return earned by equity investors over fixed-income investors averaged almost 4% annually.
Four percent compounded annually over a lifetime will create almost unimaginable differences in terminal wealth. Despite this, even with suitably long investment horizons and the goal of wealth maximization, most investors are underexposed to equities due to their perceived risk. Though greater volatility is almost certain with higher equity exposure, history shows this risk subsides substantially – and ultimately disappears – with the passage of time.

My intention is not to discount the use of bonds; certainly an investor’s willingness and ability to remain fully invested during inevitable periods of high volatility warrants consideration of having bonds in the portfolio. However, for those looking to maximize their wealth there is strong justification to have a significant capital allocation to equities to achieve that goal.

Mutual funds have a lifecycle not too different from any living entity: They are born, they grow up, and then, eventually, they die. Unfortunately, many funds perform very poorly and are sent to an early grave, taking much of their shareholders’ original investment with them.

Since the founding of the first mutual fund in 1924, the number of funds in the industry has increased dramatically. According to the Investment Company Institute, the mutual fund industry’s trade association, today there are almost 8,000 mutual funds managing more than $11 trillion dollars:

This huge number of funds, most of which have a team of portfolio managers and analysts scouring the investment landscape for the highest return on their capital, greatly contributes to the efficiency of the market, quickly pushing securities prices to fair value.

The enormous competition also makes it extremely difficult for these funds to add value by finding securities that are mispriced. Managers who build their funds on this strategy often fail, usually after a prolonged period of painfully poor performance. This results in asset redemptions by the fund’s shareholders, ultimately making the fund unprofitable to operate.

The attrition rate for mutual funds is huge. Over the past decade, about 10% of the funds in any given year have either been closed down or merged:

The investment industry preaches about the virtues of a long-term investment view, but a 10% failure rate for mutual funds means the average fund will not last nearly as long as most of their shareholders’ investment horizons!

Though a fund closing can have an obvious negative impact on its shareholders, often it’s viewed as a blessing by the fund company, because it allows them to wipe the slate clean and move forward. You may be surprised to know that, when a fund is liquidated or merged, its substandard performance simply disappears. It’s as if the fund (and the wealth it destroyed) never existed! This allows a company to claim all of their funds have delivered great performance even if many of their funds have been closed or merged due to poor performance. By intent and design, many fund companies can legally distort investors’ perceptions about their fund family’s track record of success.

This also has a profound impact on fund-industry statistics, creating a phenomenon known as survivorship bias. Survivorship bias upwardly skews the number of funds that have beaten a given benchmark because many of the funds that performed the very worst and were closed or merged into more successful funds – historically about 10% of the fund population – are excluded from the data set.

Something to keep in mind the next time you come across those glowing mutual-fund ads in the consumer press!

The recent market volatility has created anxiety for many investors who have excess cash to invest in the equity markets. With painful memories of the 2008-09 downturn still fresh, many investors are, understandably, hesitant to put a significant amount of money into stocks all at once.

Faced with high levels of volatility and economic uncertainty, should one fully invest new money today or dollar-cost average (i.e., invest a portion of the total amount to be invested at set time periods) in an effort to reduce timing risk? Interestingly, looking at the historical data, it seems the correct choice to maximize one’s wealth is to invest all at once - today. Let’s examine why.

The table below shows the monthly returns of the S&P 500 over the past 84 years:

This shows the S&P has generated a positive monthly return 61.78% of the time. Because short-term market prices are a random walk (meaning they are unpredictable), investors who dollar-cost average on a monthly basis have a higher probability of averaging into a higher market, thereby increasing the cost of their investment.

Moreover, spreading the dollar-cost average over even greater time periods, such as quarters or years, will only increase this probability. Because the market has a positive expected monthly return, the longer the time period, the more likely this expected return will materialize into actual positive returns - returns the investor will subsequently miss because he is sitting in cash:

Some investors believe that market losses are “clumpy” (meaning losses tend to be followed by more losses and one should therefore postpone investing until volatility subsides), but history has shown this, too, is a low-probability event:

As you can see, even the shortest time periods – monthly – have only seen about a 15% occurrence of consecutive negative returns. When we look at yearly returns, that occurrence drops by half; in other words, history shows that 93% of the time a down year is NOT followed by another down year.

So, while many investors believe dollar-cost averaging minimizes timing risk, there is also clearly a cost to waiting to invest. Past history gives us a clue about that expected cost, which can be measured as the difference between the S&P 500 return and the one-month Treasury bill:

To be clear, over short investment horizons either strategy may produce vastly different levels of wealth; however, those with a short investment horizon may want to revisit whether equity investing is even appropriate. 

For individuals with suitably long investment horizons, the data supporting a lower expected return by dollar-cost averaging is consistent with Modern Portfolio Theory. Cash investors assume less market risk and therefore have a much lower expected return than equity investors. Any strategy that extends the length of time an investor holds cash, such as dollar-cost averaging, has a much higher probability of costing that investor real dollars compared to what they would have earned had they invested all at once.

Someone once said that the difference between unethical and ethical advertising is that unethical advertising uses falsehoods to deceive the public, while ethical advertising uses truth to deceive the public. Looking through all the mutual fund ads that run in the consumer press, it appears the investment industry has become expert in the latter.

With 45% of Americans investing in mutual funds, accounting for more than $9.6 trillion dollars, competition is fierce in the industry. Just about any newspaper or magazine will have advertisements like the one pictured below by Putnam Investments:

Covering two full pages in Investment News magazine, it was impossible for the reader to miss this ad and its clear message: Our managers are talented and experienced, and our funds have delivered exceptional performance.

While the ad is truthful, there is a larger truth that isn’t being communicated: For most of these funds, all this talent and experience has not translated into added value for the funds’ shareholders when measured against a passive benchmark.

The ad leans heavily on the managers’ outperformance against Lipper Categories, but these are not the same as a passive benchmark. Lipper Categories are simply group comparisons, comprising data gathered from other actively managed funds; given that over any measured period it is common to see 50% to 80% of actively managed funds fail to beat their passive benchmark, using Lipper tells me the Putnam funds beat a bunch of other actively managed funds which on average fail to beat their passive benchmark. Essentially, by using a Lipper average, Putnam has lowered the bar.

Second, the advertisement touts a single year’s performance (2009). Measuring performance over a single year tells investors absolutely nothing other than it would have been nice to have held those funds for that year. Past performance, especially only a single year’s performance, cannot be extrapolated into the future, and leading investors to believe it can is disingenuous.

So what happens when Putnam’s Large Cap funds are properly benchmarked against passive indices over an extended time? The table below shows how the funds in the ad stacked up over the past 10 years to an appropriate market benchmark.
 

^{Morningstar Direct April 30, 2000-April 30, 2010}

On both a nominal-return basis and risk-adjusted basis as measured by the Sharpe Ratio (return per unit of risk assumed), only two of the six funds (33%) added any value at all. And the two funds that did add value barely did so once the amount of risk they assumed was factored in. So while it is certainly true that 100% of the Putnam U.S. large-cap funds beat their Lipper Average in 2009, considerably less have beaten their passive benchmark on a nominal or risk adjusted basis over a meaningful period of time.

This is very similar to what the broad-based data confirms and what we see on a daily basis: the majority of actively managed funds can’t beat their passive benchmark. Delivering market-beating returns is a difficult thing to accomplish for mutual funds, so most fund ads seek to change the yardstick by which they are being measured to avoid this unpleasant truth.