I recently attended a one-day investment symposium put on by the National Association of Personal Financial Advisors (NAPFA) in St. Louis, Missouri. The morning session centered around the importance of diversification, the dangers of timing markets, and the poor performance of active management over the long run, particularly in the hedge fund space.
While this was nothing new given our investment philosophy, a statistic caught my attention about the timeframe the average investor considers “long-term” in regard to investment horizon. I don’t have the exact numbers or sourcing, but the basic gist is: most investors cited in this particular study thought of three years as being long, five very long and 10 representative of a lifetime of investing.
You know that sad trombone music when someone loses a game on The Price is Right? That’s what was playing in my head when I heard this.
That’s not to say that investors are fully to blame for their short-term thinking. Advertising for investment products regularly tout one, three or five-year performance. The financial media often does the same. Of course, it’s always followed by the infamous, “past performance is not indicative of future results,” but these short-term statistics play to how we’re pre-wired to misjudge these things and the damage is done.
Making investment decisions based on one, three or five-year potential outcomes is more like speculating or gambling than investing in markets for long term benefit. Nobel Prize winning Economist Eugene Fama, when confronted with data on five and ten year premiums investors receive in certain asset classes once said, “Five or ten years is garbage, it’s basically noise. 35 years is what you need to conclude that the equity premium is undeniably positive.”
This doesn’t mean that anyone who doesn’t have 35 years to invest should quit and walk away. It just stresses the importance of putting thought and analysis behind goals, risk tolerance, diversification and, perhaps most importantly, allocation between stocks and bonds. In other words, having a plan and maintaining discipline around that plan when investing.
Historically over a 20-year span or greater, virtually all premiums an investor seeks in a diversified, balanced portfolio (i.e. size of company, value vs. growth, profitability, etc.) should be evident. While it can sometimes be tough to think that far down the road, even retired investors are likely to live multiple decades and require this growth to maintain standard of living.
Results can vary widely based on the specific model, but the probability of loss in a well-diversified portfolio in a one, two or three-year window, while better than many investment strategies, is still too high to recommend investment for funds that will be needed in that same timeframe. These probabilities improve greatly after five years and drop precipitously at 10 years and beyond.
So, what to do with short-term money? As usual, it all depends on individual circumstances, but there are a few good rules of thumb to follow.
Emergency savings should be just that, readily available for emergencies. These funds should be in cash or cash equivalents so that when the unexpected occurs, investors aren’t forced into liquidating long-term investments at an inopportune time.
Other short-term goals, like saving for a down payment on a new house or a new car should also steer clear of significant risk. It can be tempting over a few years to want to try and speed up the pace of saving through market growth. But, as mentioned earlier, the risk of loss even in a well-diversified portfolio over a short period of time is too high to risk any funds earmarked short-term goals.
If an investor is relying on their portfolio for income, it can be wise to ensure there’s at least three to five years in cash needed available in cash and shorter term, higher quality bonds. This allows an investor to avoid selling stocks during a market downturn by having plenty of cushion to provide the money needed while stocks recover.
It can be difficult to get our head around it sometimes, but over a lifetime of investing, investors are almost certain to see markets of every stripe. While it’s tempting to want to jump from one thing that has done well for a short period of time to another when that other investment invariably under performs, this is the very definition of selling low and buying high which is the last thing an investor wants for their portfolio. Far better is having a resilient plan in place that meets needs regardless of market conditions. It takes the patience of seeing the long-term for what it is, but is ultimately the best way to have a successful investment experience.