There is a widely-held view that the longer the holding period for an investment, the more volatile the asset that can be invested in. There seems to be two beliefs contributing to this headline view:
- The more volatile the price of the investment, the greater the ultimate return; and
- Short-term volatility will ‘wash out’ over the long-term.
I can rationalise how taking greater risk (of capital loss) might result in greater return. However, I challenge whether short-term volatility of the price of an asset represents risk to anyone besides a correspondingly short-term trader of the asset. I also question whether this short-term volatility washes out over the long-term, however these ‘terms’ are defined, for most (but not all) assets.
There might be an issue of causality at play when examining the link between the volatility of the price of an investment and the ultimate return, particularly in the case of an equity investment. High returns might be the result of the successful execution of a business plan that is more likely to fail than succeed. This business plan is consequently defined as having a high risk of failure and resulting capital loss. The likelihood of success might be low and/or uncertain during the course of the execution of this business plan, leading to wildly changing assessments of the value of the equity as represented by the price. Is the ultimate outcome the result of the (third-party/market) assessments made during the course of the execution programme or independent thereof? Conversely, are the interim assessments not a reflection of the perceived likely success of execution?
Volatility of price in the short-term might be largely independent of the ultimate return delivered. Take the case of index-linked government bonds with a maturity of over 50 years. The price of these instruments changes by over 50% for a 1% p.a. change in the yield to maturity – a move that has been seen in the last two years. This price volatility does not impact the real return earned by an investor who has bought such a bond, knowing the total prospective real return at the point of purchase, and holds it through to maturity (assuming the government in question makes all the payments due). This high short-term price volatility has been associated with what many consider a low prospective return, namely around 1% p.a. below the rate of inflation as measured by the Retail Prices Index. A short-term trader of this bond would have been exposed to the impact of these price changes, potentially generating material profits or losses.
The view that short-term price volatility will wash out over the longer term is, in part, a function of the way that volatility is calculated. Longer-term price volatility is proportional to the square root of the shorter time period being considered, leading to a natural relative compression of the volatility statistic as the time period lengthens. This calculation approach assumes that changes in price over the shorter periods are independent of one another – a questionable assertion. For example, the volatility of price over a 400 day period is 20 times the volatility of the same price over a one day period. This effect is often referred to as the ‘funnel of doubt’ – i.e. the range of annualised returns decreases as the time period increases. However, this effect is illusory for investors.
The change in the value of an investment that matters to the investor is the total change over the ownership period rather than the annualised return. The longer the time period, the wider the range of total change is likely to be. A difference of 2% p.a. translates to a range of 22% after 10 years, 64% after 25 years and 170% after 50 years.
A long-term time horizon does provide more opportunity for an asset to rebound if the price falls than a short-term time horizon. However, such rebounds are far from guaranteed – quite the opposite might just be the case. Keynes commented that “markets can remain irrational a lot longer than you and I can remain solvent”. His definitive take on the long run was that we ultimately all end up dead. The investor’s time horizon does play a role in defining the investment strategy but should it be the primary determinant of the quantum of risk (however risk is defined) that can be taken on?
A lot of very valid observations Henry. A common error that I hear is that ‘the risk of investing in equities diminishes over time’. Indeed for many investors with a defined time horizon (e.g. those saving towards their pension) price volatility arguably matters less in the early years of saving and increases the closer they get to retirement. The other issue that I find very interesting is the whole question of volatility in retirement when income volatility overtakes price volatility as a primary concern and thus instruments such as inflation linked bonds become more attractive despite their sometimes extreme price volatility.
Ralph is the person you should commend Richard! Far too clever for my blogs!