Time
In The Lord of the Rings, Gollum's final riddle to Bilbo Baggins was:
There are many types of risk. For this discussion I focus on two critical types of risk which I will name "volatility" and "destruction".
Volatility is the risk that comes because prices move both up and down. The bigger the moves, the higher the volatility. You might think of this as the price being less dependable.
Destruction is the risk of the investment permanently going away (think bankruptcy for a company). You might think of this as fragility. A very fragile company cannot withstand very much bad news.
Time relates differently to each of these types of risk.
For volatility: time decreases the risk significantly. The scatterplots below show the range of annualized returns over the past 30 years for different holding periods for each of the four asset classes I use in my portfolios. There is a separate chart for each asset class.
In every case, the longer you hold the security, the smaller the range of outcomes, and the fewer negative outcomes there are. This happens because prices can move drastically in one direction over short periods but in the long run they tend to revert back.
Note: I cut off the downside at 100% but some of the single month outcomes were -300% or more when annualized. I also put the most volatile asset class at the top and worked down to the least volatile asset class.
For destruction: time increases the risk. Every day you hold something is another potential day for disaster. For very fragile companies time adds a lot of risk but for very secure investments the change is very small.
This risk can be dampened by diversification. See the chart below for the impact of one investment being destroyed if you have 1, 10, or 1000 investments in your portfolio.
This is the primary benefit diversification offers to a portfolio. Be careful though, many people mis-use diversification. They try to use it to dampen volatility or poor investment decision risk. It is not well suited for those purposes.
In summary: You have to take on risk if you want returns. We have discussed the influence of time on two main types of risk (Volatility and Destruction). Time dampens volatility risk, so the longer you intend to invest, the more volatility you can put into your portfolio. Alternatively, time increases the risk of destruction and while destruction does not occur often, the result is very harsh. We can reduce the impact of destruction through careful and deliberate diversification.
One final note: Be wary of investments that seek to reduce risk through structure or insurance. You give up a lot of return for these products and they often do not perform as expected when risk bears its head.
This thing all things devours: Birds, beasts, trees, flowers; Gnaws iron, bites steel; Grinds hard stones to meal; Slays king, ruins town, And beats high mountains down.The riddle's answer is "time". Time has a huge impact on all things. In my previous post "Why Now" I discussed the important impact of time on investment returns. In this post I would like to discuss the impact of time on risk.
There are many types of risk. For this discussion I focus on two critical types of risk which I will name "volatility" and "destruction".
Volatility is the risk that comes because prices move both up and down. The bigger the moves, the higher the volatility. You might think of this as the price being less dependable.
Destruction is the risk of the investment permanently going away (think bankruptcy for a company). You might think of this as fragility. A very fragile company cannot withstand very much bad news.
Time relates differently to each of these types of risk.
For volatility: time decreases the risk significantly. The scatterplots below show the range of annualized returns over the past 30 years for different holding periods for each of the four asset classes I use in my portfolios. There is a separate chart for each asset class.
In every case, the longer you hold the security, the smaller the range of outcomes, and the fewer negative outcomes there are. This happens because prices can move drastically in one direction over short periods but in the long run they tend to revert back.
Note: I cut off the downside at 100% but some of the single month outcomes were -300% or more when annualized. I also put the most volatile asset class at the top and worked down to the least volatile asset class.
For destruction: time increases the risk. Every day you hold something is another potential day for disaster. For very fragile companies time adds a lot of risk but for very secure investments the change is very small.
This risk can be dampened by diversification. See the chart below for the impact of one investment being destroyed if you have 1, 10, or 1000 investments in your portfolio.
This is the primary benefit diversification offers to a portfolio. Be careful though, many people mis-use diversification. They try to use it to dampen volatility or poor investment decision risk. It is not well suited for those purposes.
In summary: You have to take on risk if you want returns. We have discussed the influence of time on two main types of risk (Volatility and Destruction). Time dampens volatility risk, so the longer you intend to invest, the more volatility you can put into your portfolio. Alternatively, time increases the risk of destruction and while destruction does not occur often, the result is very harsh. We can reduce the impact of destruction through careful and deliberate diversification.
One final note: Be wary of investments that seek to reduce risk through structure or insurance. You give up a lot of return for these products and they often do not perform as expected when risk bears its head.
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