How Time Perception Influences Investing Decisions

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Most people intuitively understand that time is a critical component of investing.  Whether it’s the time it takes to work and save a portion of every paycheck or the miracle of compound interest that gets better and better as you go, the importance of time is a central part of any detailed investing discussion.  But the human brain is sometimes ill-equipped to comprehend things that are far away, and that can lead to some mental over-simplifications that obscure the reality of future uncertainty.  For example, let’s talk a bit about a question I see come up pretty often:

 

Do stocks get less risky the longer you invest?

 

Of course, I’m not aware of anyone who actually believes that there’s a guy on Wall Street who keeps track of you personally and adjusts the markets accordingly.  Still the belief that investing for the long run will not only help you avoid panicking during a short-term market drop but also virtually guarantee superior long-term returns is a relatively pervasive mindset in personal finance circles.  But where does that belief come from?  And is it true?

The idea that stocks are risky in the short term but safe in the long run comes from an astute observation about how returns averages change over time, and it is illustrated very clearly in the Long Term Returns calculator here on the site.  Here’s an example for a portfolio containing 100% US Stocks.

 

time1

 

For a little background, this chart maps the full range of real-life outcomes for a 100% US stock portfolio looking at every single start year since 1970.  The vertical axis shows the inflation adjusted compound annual growth rate, which is the average annual return above inflation that the investor experienced.  The horizontal axis shows the number of years that they were invested.  The shaded blue area represents the full range of returns for every investor, while the dark blue line represents the median return.

You can see from this chart that while the median real CAGR was relatively constant no matter how long you invested, the range of possible outcomes varied a lot by timeframe.  After one year the range was anywhere from -40% to +35%, and after 20 years the range was a much tighter +5% to +14%.  So clearly, the longer you plan to hold an investment the easier it is to have a good idea for the average return.

Lots of people stop here, take the long-term median return, and use that number to project their own future portfolio growth.  The numbers are based in good historical data and the math is very simple.  With a well-reasoned argument like that, what’s the problem?

Well, it’s a little more complicated than that.  To explain, let me first offer a bit of a view behind the scenes of the calculators and show you the same chart that tracks every individual start year.

 

time2

 

Here you can see why I simplify the long term returns charts a bit, as every historical outcome becomes a tangled mess of lines.  But showing it this way does help drive the point home that every line was the actual experience of a real-life investor, and none of the averages were particularly steady.  They changed all the time, and nobody experienced that median return every year.

But beyond the fact that none of the lines are even close to straight, the problem with relying on this chart alone is that it misses an extremely important time-based factor in any investment decision — compound interest.  A tight 4% band of average returns 30 years out may sound really predictable, but a 4% return compounded over 30 years makes for a big difference in final portfolio values.  How much of a difference?  Let’s take the same chart and track how the real CAGR translates to actual account values over the years invested.  For reference, each line color between charts represents the same start year.

 

time3

 

That tells quite a different story!  Averages can be very deceptive, and once the rubber hits the road with real-life compounded account values, the uncertainty of a 100% stock portfolio clearly increases over time.  Averages are not the same thing as portfolio account values, and investors who mentally justify a risky portfolio under the belief that time will reduce risk could be in for a rude awakening!

For long-time Portfolio Charts readers, that last chart might look a little familiar.  Let’s adjust the colors and see if that helps.

 

time4

 

Yes, that’s a Portfolio Growth chart.  So no matter whether you’re looking for long-term averages or long-term portfolio values, there are lots of tools here to help explore both.  And no matter how you invest, I recommend looking at your portfolio from a variety of different angles.

The fun thing about these tools is that they can also be incredibly useful to explore the world of asset allocation beyond stocks.  Does the uncertainty of US stocks worry you?  If so, browse the portfolios and look at how asset allocation can tighten up the charts for both the long term returns and also the portfolio growth.  Not every portfolio is equally uncertain, and perhaps an alternative will help you meet your financial needs with a fraction of the possible volatility.

So circling back to our original question, where does all of this leave us?  The short story is that the longer you invest without switching portfolios, the smaller the range of average annual returns but the larger the range of actual portfolio values.  But not every portfolio has the same range of outcomes, and you need to study them individually from many angles to find one that works best for you.  The effect of time and uncertainty on your investments is a difficult concept to understand, but the time you take now to explore the subject and find a portfolio you’re comfortable with will pay big dividends to your future happiness as an investor.

Do you truly understand the impact of time on your own investments?  If not, don’t be discouraged and don’t give up.  Take charge!