Might your risk in holding stocks go up the longer you hold them?
It is almost sacrilege to ask. One of the most bedrock of bedrock principles of retirement planning is just the opposite—that your risk declines with time horizon. That is the source of the nearly-universal advice for young adults to put 100% of their retirement portfolios in equities and then gradually reduce that allocation as they approach retirement.
But it is the job of the contrarian to question that which no one else questions, and that’s what I am going to do in this column.
To do so, I reached out to Zvi Bodie, who for 43 years was a finance professor at Boston University. Bodie has devoted much of his career to researching issues in retirement finance, and he is a contrarian when it comes to the long-term risks that equity investors face.
In an interview, Bodie said that there is one sense in which the conventional wisdom about stocks’ long-term risk is right, and another in which it is dangerously wrong. Almost everyone focuses on the first and ignores the second.
The sense in which the conventional wisdom is right: The longer you hold equities, the less likely you will lag the risk-free rate, such as Treasury bills. This has certainly been the case over the last two centuries, as you can see from the accompanying chart.
That certainly seems to provide strong support for the conventional wisdom. But what this way of analyzing the data overlooks, according to Bodie, is the magnitude of the loss when stocks do lag the risk-free rate. And as holding period increases, the magnitude of the potential loss grows.
This is a subtle but crucial point: Even though the odds of losing go down with holding period, the size of your potential loss grows.
To illustrate the net effect of these two trends, Bodie calculated what an insurance company would charge you if you wanted to insure against the possibility that, at the end of a given holding period, you have earned less than the risk-free rate (such as with Treasury bills). With such insurance, of course, you could sleep easily with an all-equity portfolio, knowing that your worst possible outcome would be to do at least as well as putting your money in a money-market fund.
Note carefully that no insurance company currently offers this kind of insurance. Nevertheless, there are standard theoretical formulas for calculating what an insurance company would need to charge in order to assure its own solvency. Utilizing such formulas, Bodie found that, as time horizon lengthens, the cost of insurance rises—as you can see from the accompanying chart.
This result stands almost all of retirement financial planning on its head, and I wondered what pushback Bodie received upon publishing it (in, for example, the May-June 1995 issue…