My wife and I are science fiction fans. One of our favorite shows is the BBC remake of Doctor Who, the longest-running television science fiction show. One of my favorite quotes from the show is David Tennant's description of time:
People assume that time is a strict progression of cause to effect, but actually, from a non-linear, non subjective point of view it is more like a big ball of wibbly-wobbly timey-wimey...stuff.
Unfortunately, I and the regular readers are not Time Lords, so we're stuck with the more pedestrian concept of time, which is that it's more of a linear, cause and effect thing. And that leads us into the topic of today's post: the inter-relationship of risk and time. You see, traditional investment thinking goes that the farther off into the future someone needs the benefits of a portfolio, the more risk they can take. Suppose you're saving for retirement and you're in your mid-20s, you should think about allocating a larger percentage of your investment to riskier assets because they also have the potential for more gain. And, should they lose value in a market sell-off, you'll have longer to make your money back. There is a drawback to this thinking, however; the more risk you take, the more variable your potential results.
I'll start with a portfolio of EEM: Above are the various potential returns which show a huge divergence of potential outcomes. The portfolio could go gangbusters over 30 years, turning a $1 million investment into nearly $60 (the blue line above). But it's also possible that the portfolio barely returns anything (relatively speaking; the purple line). Those outcomes are shown in the following table: Even after 30 years, there is a very large fluctuation in the expected annual return (far left column); the 10th percentile is .24% while the 90% percentile is 14.42%.
All of this data makes sense as emerging markets are by definition potentially very risky investments. It's possible that the underlying country performs like China starting in the early 1990s. But it's just as likely that the outcome is like some African countries in the 1970s.
Let's turn to SPY: There is still a large difference between the 10% and 90% percentile outcome. But it is smaller. And there's a smaller difference between the returns of the different percentile outcomes: By year 30, the 10th percentile outcome is 4.5%; the 90th percentile outcome is 13.45%. The overall difference between these outcomes is about 9%. And the possibility of a large loss is less: There's a 24.7% possibility of a 20% loss - less than half that of the EEM.
Finally, here's the same data for the IEI: The first thing to notice on the possible outcomes is that there is a far smaller amount of difference between the 10th percentile and the 90th percentile. The reason is there's far less risk associated with this section of the Treasury market.
We see this lack of volatility in the returns: By year 30, there's only a 2% difference in the potential expected annual returns of the 10th and 90th percentile outcomes. But there's also a far smaller possibility of a large loss: In fact, there's almost no possibility of an extremely painful drop in the portfolio's value.
Time amplifies risk. Yes, it's possible that a risky investment could create massive returns over an extended period of time. It's also possible that the risk amplifies the potential losses, so the gain isn't as large as we hoped. As investments become less risky, they return less, but the return is potentially a bit more stable.
The key question to ask yourself is this: what kind of a hit to your portfolio can you live with? Suppose you invest $10,000 in investment "x" and you have a bad year, leading to a final portfolio value of $7,500, is that something you can emotionally accept? If not, a less risky investment would be more appropriate. But that also means you're accepting less potential return.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.