By Tony D’Andrea, CFP®
Tony is a CERTIFIED FINANCIAL PLANNER™ and Certified Public Accountant who has worked in Chattanooga his entire career. He is a Senior VP-Investments and Branch Manager with Round Table Advisors of Raymond James in Chattanooga, TN. Tony is a past President and an active member of the Chattanooga Chapter of the TN Society of CPA’s. He is also an active participant in the community, serving on many boards of local and regional non-profits.
Surprised? Many people today don’t realize the long-term potential of investments because they tend to think of the most recent trends. The stock market has clearly been a wild ride over the last dozen years or so. With this in mind, this article will attempt to bring everyone back to the realities of investing and help you understand that TIME IN and NOT TIMING the market is what is most important to long-term success.
Among the major asset classes shown below (we have only included those asset classes that have been tracked since 1926), only stocks have outperformed inflation by a wide enough margin to create true wealth in the long run:
If this is true, then why not just put all your money in small-cap stocks and “let it ride?” As Bob Dylan said, “The answer my friend is blowin’ in the wind.” That’s what could happen to your money in the short term if you invest it all in small- or large-cap stocks. The concept of time is extremely important when it comes to investing your money.
Here are the same asset classes identified above showing the range of annual total returns from 1926 to 2012:
Notice anything? Clearly, the higher returns achieved in small and large stocks come at a potential risk of loss with the most significant potential occurring in the shorter holding periods. In any given year, you could have lost 58% if you were invested 100% in small-cap stocks. If you stayed invested in small-cap stocks over the entire 86-year period from 1926 to 2012, then your return would have been 11.9% compounded as shown above. Miss any part of that time frame and who knows what your return would have been.
Another way to look at this volatility of returns is to look at longer holding periods. The chart below shows these same asset classes again, but now compares holding periods of 1-year, 5-years and 20-years:
Now the clear pattern emerges showing that longer holding periods decrease volatility substantially. Keeping in mind that there are many other risk factors to consider when investing, the idea of your holding period for your investments is one of the most important to consider.
Because of the greater potential for short-term loss in stocks, we recommend to our clients that they think of their money or investments in terms of how soon they will need this money and only invest in stocks if they will not need this money for at least two or three years. Ideally, if you can estimate your needs in terms of the next two to three years, the next three to six years, and then everything beyond that, you will have identified the segments where you can invest more of your money in stocks.
Now with these time frames in mind, our recommendations for how much stock to hold in each segment are as follows:
Short Term – For spending needs that would occur within the next one to three years, we would recommend a very conservative portfolio of mostly cash and cash equivalents such as CDs or high-quality, short-term bonds and very little, if any, stocks. Any stocks owned in this segment should be high-dividend stocks with a long track record for increasing dividends over time. This allocation would provide the most stability and lowest risk of loss for your most current needs. You could pull from this segment for up to three years and not touch any of your other investments if the market were to perform poorly. Ideally, as the other portfolio segments perform well, you could replenish this segment with gains from the others.
Mid Term – For the next segment of spending needs (three to six years), we would recommend a more balanced portfolio with roughly 40% invested in stocks (a mix of large- and small-cap stocks and also international). The remaining investments could be a mix of fixed income (bonds) and cash or cash equivalents. Although there is greater potential for loss in the short term, this portfolio could be left untouched for at least three years should the market turn down or go through a bear market for a prolonged period of time. When the stock market is generally up and this portfolio has gained in value, then you could reassess your balances either quarterly or semi-annually and pull from this portfolio into the shorter-term portfolio. Otherwise, you can let the market run its course and wait for this portfolio to provide better returns before pulling anything from this segment.
Long Term – The third and last segment is your long-term or growth segment of your portfolio and where you would want to own most of your stocks. We would recommend upwards of 60-70% of this segment’s overall investments be in stocks. Given that you would have identified that you would not need this money for at least seven years or so, you would be able to keep the investments in stocks and not touch them for that length of time should the market turn down. The reassessment of your needs each quarter or semi-annually will provide the opportunity to pull gains from this segment to replenish the mid-term and short-term segments if the portfolio has grown in value or your shorter-term needs have changed. More importantly, if this segment is down, just leave it alone for as long as needed or up to the complete seven-year period if necessary. This will give you the best chance to recover from the inevitable market downturns that you will experience.
Overall, stocks are still your best chance for gains in the long run, but you must realize and understand how long you will be able to keep your investments without cashing them out. Remember what Mick Jagger once said: “Oh time, time, time is on my side, yes it is….” And it will be on your side if you just stick to this time-tested plan for your investments!