Dispersion and Uncertainty

Do Longer Time Periods Increase Stock Market Risk?

It is often said that the risk of stocks diminishes with time. The argument is that if you invest for long enough you’ll be just fine. There is also a minority crowd that claims the risk of stocks actually increases with time. This argument is based on the premise that over longer periods of stock market investing your range of possible outcomes increases. However, I believe there is much confusion about this topic, and our conclusion will depend on how we define risk.

In the following table I have reprinted some data that I posted in a previous article. It is not a table of pure stock market returns but rather the returns achieved by a person using a long-term DCA program. The values are derived from Robert Schiller’s dataset dating back to 1871. The savings rate is $5,000 real dollars added at the beginning of each year to the S&P 500 index, over rolling periods of 30, 25, 20, 15, 10, and 5-years. The percentiles show the likelihood of achieving a result of that or better.

Years

100%

90%

10%

1%

IRR

Value

IRR

Value

IRR

Value

IRR

Value

30

1.075%

$177,798

3.545%

$269,251

9.722%

$856,252

10.794%

1,059,875

25

-0.130%

$122,909

2.511%

$175,326

10.615%

$596,852

12.630%

$827,525

20

-1.920%

$82,092

1.671%

$119,550

11.653%

$386,413

14.180%

$530,803

15

-3.722%

$56,112

0.408%

$77,495

12,879%

$225,887

15.492%

$286,090

10

-7.936%

$32,632

-0.945%

$47,474

14.094%

$110,820

22.857%

$183,672

5

-14.071%

$16,229

-2.621%

$23,102

18.532%

$42,847

31.608%

$61,380

As would be expected, the range of IRRs is greater for the shorter periods, but the absolute range of dollar values is greater for longer periods. However, what we are really concerned with is the degree to which the best dollar outcomes are greater than the worst. In the table below I will compare the 100th percentile to the 1st percentile, and the 90th percentile to the 10th percentile by way of the difference between each. Larger numbers indicate greater dispersion.

Year 1st/100th % 10th/90th %
30 5.96 3.18
25 6.73 3.40
20 6.47 3.23
15 5.10 2.91
10 5.63 2.33
5 3.78 1.85

By examining this data I believe the situation is not so simple as some make it seem. Regardless of whether we look at the upper and lower values, or at the 10th and 90th percentiles, the larger dispersions come during the 20 and 25-year periods. I can’t say why, but the relationship is far from linear. Still, the numbers are clearly the smallest in the 5-year periods. Yet few people would argue that anybody should be heavily invested in stocks over a 5-year timeframe.

If your definition of risk includes the possibility of achieving very bad outcomes, then I think the shorter time periods start to seem pretty scary, as they contain the possibility of strongly negative returns. Either way, in my opinion the takeaway here is not whether one period is riskier than another. The takeaway is that for somebody who is investing for 25 or 30 years, they face a great deal of uncertainty in their final outcome. Whether or not that is synonymous with risk is in some ways up to you.

But the real question is what does that uncertainty mean for an investing program. What it does not mean is that we should avoid the stock market. For most people stocks are a necessity to achieve their goals. What it does mean is that we should build that uncertainty into our planning. We can’t just plan on the average or historic stock returns. We must plan modestly, and our plan must contain some flexibility if we want a high probability of achieving our goals. Stocks may contain a great deal of uncertainty, but if we build that uncertainty into our plan, the plan can have a good chance of success.

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