Today I’ll continue the thread on lifelong investing, which started here. In the second post in this series, I discussed the effect of volatility. I the discussed diversification in the third post in the series. Today, I’ll discuss the effect of time frame on investment risk and appropriate investments based on time frame.
The third concept affecting risk and return is time frame. Time frame is the amount of
time an investment is expected to be held. Purchase of high
volatility assets would be nothing more than gambling if one were
planning to invest for a few months or a few weeks. Likewise, buying
lots of shares of a single stock for a short period of time is very
The reason stock prices are difficult to predict over short periods of time is that the
changes are due to changes in the random component of the price. The
price of a stock at any given time factors in all of the current
news. The base price – the non-random part- for the stock is set
based on current earnings, business prospects, the state of the
economy, politics, and other factors. It therefore makes no sense to
buy or sell a stock due to the news that comes out – it is already
priced into the stock. On top of the base price are seemingly random
fluctuations due to the effect of various trading strategies,
investor emotions, and things unrelated to the company going on in
the investors’ lives.
When buying stocks for short periods of time, all of the effects due to the stock’s
fundamentals have been priced into the shares. It has been shown
that one would actually do better picking stocks throwing darts at
the financial pages than by trying to select them when the period is
a year or less. This is true even if professional money managers are
doing the picking.
Because short-term changes are only due to random effects, it is difficult to predict
price over short periods of time, between one and three years. The
random component of a share price can be as large or larger than the
fundamental component, and therefore the price for shares presented
by the market are not necessarily rational at any given time. Stocks
that are overpriced can continue to rise. Those that are dirt cheap
can get cheaper. Often this is due to investor emotions – one who
sees money being made may buy because he is expecting to sell for
more later. One who has lost money may sell at a low price to just
get out, and others may not buy for fear of seeing the price drop
Even if one buys shares in a great company, the general market sentiment can cause the price
to fall and stay down for short periods of time. There is also
manipulation, various trading strategies, and all kinds of random
events that can affect prices over the short-term. Maybe you’ll buy
that great stock and then the founder will decide to unload a bunch
of shares and buy a house.
It is much easier to predict stock prices over long periods of time because the price will
eventually follow the fundamentals – the random portion is just a
ripple on top of the fundamental price. A stock’s price does not
immediately move in price due to the expected future return, for
example, it will not double in price if earnings five years down the
road are expected to double. The reason is that there is risk
involved in the company actually achieving the expected earnings.
The current price is less than, or discounted
relative to the expected future price, to reward the investor
sufficiently for taking on the additional risk.
It is due to this discount to account for the risk being undertaken that stocks do
better than most assets over long periods of time. In addition,
stocks have a natural tendency to rise as the economy grows and
earnings increase. Returns on stocks over long periods of time have
averaged between ten and fifteen percent — much better rates that
most other investments.
Also, buy buying shares regularly, rather than putting all of one’s money in at once, one
can also lessen the effects of market fluctuations since more shares
will be bought while prices are low than when they are high. This
process, called “dollar cost averaging,” is a popular and
So the allocation of assets into bank accounts, bonds, stocks, real estate, and other
investments is highly dependent on time frame. For those with only a
few years to invest, the money should be safe in a bank CD despite
the terrible interest rates. For those who are saving for retirement
and have decades to let the money grow, the money must be in assets
with more return than the bank or inflation will decrease the actual
value of the account each year.
So to summarize, volatility increases risk but also increases potential return.
Diversification decreases risk by reducing the effect any one asset
can have on total portfolio value but also reduces potential return
to that of the market. Increases in time frame reduce risk since
assets tend to increase in value with time, time allows assets that
have fallen in value to recover, and it is much easier to predict
which assets will do well over longer periods of time than shorter
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.