Risk and your Time Horizon

So far we've been seeing that the stock market is unpredictably risky in the short run. The good news is that long-term investors get much smoother sailing. Look what happens to volatility as your time horizon grows from one year, to ten, to fifteen or twenty:


Date range: through  
Time horizon:   years
Adjust for Inflation

S&P 500 returns (dividends included): Robert Shiller and Yahoo! Finance


Risk clearly shrinks as your time horizon grows, whether you measure risk by standard deviation or by the painfulness of the actual bad outcomes. If you're a portfolio-churning short term investor, hurting yourself in the market is as easy as falling off a high and slippery log; but with a longer time frame, even the worst outcomes are usually better than inflation.


Above-Average Risk

Strictly speaking, this calculator doesn't show that risk decreases with time; it shows that that's what has happened in the past, on average. But there's more to risk than historical averages. For example, if you buy at a time when P/E ratios are at historic highs, you should expect your returns to be below average.

Here's another example of non-random risk. Set the time horizon for ten years, adjust for inflation, and notice how the pain is concentrated around the inflation of World War I and (worse) the "stagflation" of the 1970s. There's a lesson here: you don't want the government to deal with deficits by devaluing the dollar. (This would be a good time to read Free to Choose again.)


Note About Averages

Don't be concerned that the "average" tends to shrink with time in the calculator; it's just approaching the long term annualized return rate (plus or minus some error, since the number of data points isn't constant).



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Article Contents
Market Abnormality
Significant Outliers
Ups and Downs
Long Term Risk
Momentum & Reversion
Crashes & Recoveries
Retirement Planning
Skill vs. Luck
Books & Links