Amid all the volatility in markets this year, it is worth remembering one simple risk reduction tool - time.
That is the finding of some research produced by Merrill Lynch this week. Simply, it suggests that longer-term horizons make losses less likely. This can be easy to overlook at times like now when near-term “noise” is driving markets.
Markets now seem beset by macro uncertainties - how far will central banks around the world raise interest rates? Is the long run in strong earnings growth since the bottom of the bear market coming to an end? What impact will rising commodity prices have on economic growth and inflation? How will mounting geopolitical risk affect investor risk appetite?
In short, the near-term outlook is as opaque as it gets. This matters less, however, the longer your investment horizon. Richard Bernstein, chief investment strategist with Merrill Lynch, says the probability of losing money when investing in the S&P 500 index is 46 per cent for one day.
That is 46 per cent of the daily trading sessions in the bank’s survey period from January 1985 to June 2006 ended in negative territory. As Mr Bernstein notes, is it any wonder that day-traders are generally unsuccessful?
However, the probability of losses falls to 42 per cent in any rolling one week period, 35 per cent for one month, 27 per cent for one quarter, 18 per cent for one year, 14 per cent for three years, 17 per cent for five years and zero per cent for 10 years.
Merrill Lynch says there is a similar pattern for non-US stocks. The probability of negative returns from investing in the MSCI EAFE (Europe, Australasia and Far East) index was 38 per cent for any rolling one month period. This fell to 36 per cent for any one quarter, 26 per cent for any one year, 17 per cent for any three years, 7 per cent for any five years and 0 per cent for any 10 years.
“Our analysis firmly supports our view that the current fashion of shortening time horizons might not benefit performance,” Mr Bernstein says.
There may be a case to argue that for the very long-time periods - five and ten years - the results of the research may be skewed by the long bull market in equities from 1985 until 2000. Investors had only a 4 per cent chance of losing money over a 12-month period in S&P 500 stocks during the 1990s.
But the broad trend seems clear enough and there is little reason to suppose it would be any different for UK stocks.
The patterns were similar too for small-cap stocks in the US, corporate bonds and US Treasuries. The asset classes that were exceptions to the trend were commodities, gold and art.
The probability of losing money in commodities did not significantly change for a one-month time horizon versus a five-year time frame - 45 per cent and 41 per cent respectively since December 1969. Similarly, for gold and art there was very little decline in the probability of losing money for a month time horizon versus a three-year time horizon since December 1969 for bulllion and January 1976 for art.
“Commodities, gold and art may be more appropriate investments for those who have truly long-term horizons,” Mr Bernstein says.
The other clear trend to emerge from the research is the importance of diversification. Mr Bernstein says there has never been an instance where the best performing asset class during one decade was the leader in the subsequent ten years.
As an example, gold was the superior asset class in the 1970s but became one of the least attractive in the next decade. Art went from the least attractive asset class in 1970s to the most attractive in the 1980s. And while the S&P 500 had a stellar 1990s, the average return from rolling 12-month periods since 2000 has been a paltry 2 per cent.
The clear implication is that long-term investors should follow the oldest adage in the investment adviser’s book - don’t put all your eggs into one basket. The research also makes a strong case for contrarian investing when uncertainty has depressed prices - times not unlike now.