One of the key points I made in yesterday’s post was about your time horizon, and how shorter time frames call for more caution than do longer ones. But this is actually a bigger point, which applies to multiple areas of investing and life. So, I thought I would make the discussion more general.
Looking at the long term
Let’s start with why longer-term results can be more predictable than shorter-term ones. The answer is, simply, averaging. One data point might be noisy, but as you accumulate more and average them, the outliers tend to offset each other. As a result, the signal starts to dominate the noise. The more data points you have, the closer you get to the expected result. Investors with 40 years, for example, can look at longer-term return goals with a reasonable expectation of actually getting them. But for shorter time frames, the noise can dominate. Hence, the extra caution needed as you get closer to retirement.
This trend also works in reverse. Looking at short-term results in the past (e.g., the best-performing fund on July 22, 2016, from 1:00 to 1:45 P.M. ET!) is probably looking at noise. Longer term, over five to ten years, is likely a reasonable indicator of repeatable performance. Similarly, when we look at economic data, monthly data bounces around a lot. But the year-on-year changes—which, by no coincidence, are what we use in the monthly economic update—are much smoother and more reliable.
Translating this to the actual investment process, we have the justification for longer-term investing. Any fund will do well in some environments and less well in others. Holding for the long term allows you to receive the average return, without trying to time the good and bad periods. Planning for the long term lets you match the actual performance of your portfolio with your needs. Further, planning to consistently put money in regularly for the long term lets you take advantage of times when the market is down (i.e., cheap).
What’s the takeaway?
The big takeaway here is that by matching the time horizon of your goals with that of your strategy, you are maximizing your chances for success.
When your time horizon starts to get shorter, particularly when it's below the ten or so years when performance is likely to be predictable, your goals start to become vulnerable to the noise inherent in investment returns. At that point, you need to consider strategies to realign your time frame with a time period that is reasonably predictable.
One way to do that? Simply place enough money in very-low-risk assets, allowing the rest of your portfolio to have the extra time to recover, if necessary. If your time frame is seven years, say, and you set aside three years of spending needs in low-risk assets, you would not need to touch the rest until ten years. Once again, this would match the predictable time frame against your needs.
Recipe for success
None of this is an exact science, of course, and there are many assumptions baked into what I have discussed here. As a guideline to how to think about your goals and how they relate to your investments, though, this kind of analysis can provide a meaningful framework for exactly what you might want to do, when you might want to do it, and why it might work.
As always, understanding the risks ahead of time and then planning how best to minimize them is the best recipe for success, in investing or anything else. Understanding your time frame and that of your investments is a great way to minimize the risk that noise can present to your goals. Another way to accomplish the same thing is to try to minimize the noise itself, which we will discuss tomorrow.