Investing for the long run is a very compelling mantra, but just how long is the long run? Is it 10 years, 15 years, 20 years, or even longer? Just how long does it take to achieve a long-run return?
A comprehensive study of nearly nine decades of data brings surprising results. It suggests that for the most common classes of investments, holding assets for longer periods of time did not generally improve the likelihood of experiencing a long-run return. But when an asset class underperforms its long-run return, it tends to do so more drastically in holding periods that are shorter.
For this study, four asset classes (large-cap U.S. stocks, small-cap U.S. stocks, U.S. bonds and U.S. cash) were examined under an array of investment horizons, from five years to 35 years. The overall time frame of this study is Jan. 1, 1926, to Dec. 31, 2014. In terms of performance, this 89-year period is the longest span for which data are available. So this span becomes the benchmark.
A four-asset portfolio was also evaluated. It consisted of 40% large-cap U.S. stocks, 30% small-cap U.S. stocks, 20% U.S. bonds and 10% U.S. cash. It was rebalanced annually.
As for the specific indexes that were chosen to represent each asset class, large-cap U.S. stocks are measured by the S&P 500, small-cap U.S. stocks are measured by the Ibbotson Small Stock Index from 1926 to 1978 and the Russell 2000 Index from 1979 to 2014. U.S. bonds are represented by the Ibbotson U.S. Intermediate Government Bond Index from 1926-1975 and the Barclay’s Capital Aggregate Bond Index from 1976 to 2014, and U.S. cash is represented by 90-day Treasury bills.
LONG-RUN PERFORMANCE
Over the past 89 years, U.S. stocks saw a gross average annualized return of 10.12%; small-cap U.S. stocks averaged 11.4%; U.S. bonds, 5.41%; and U.S. cash, 3.6%. The four-asset portfolio produced an 89-year average annualized return of 9.75%.
The impact of inflation on asset class returns is significant. The 89-year inflation-adjusted real return of large-cap U.S. stocks was 6.98%. Small stocks netted an inflation-adjusted return of 8.22%, bonds delivered an annualized return of 2.4% after inflation, and cash eked out a 0.53% real average annualized return. The four-asset portfolio generated a real annualized return of 6.61% from 1926 to 2014.
THE REAL QUESTION
On to the real question: How long does a client need to hold a particular asset class (or portfolio of asset classes) to achieve or exceed the 89-year real return in each asset class?
As shown in the table “Portfolio Intervals” on page 60, the findings are initially surprising. For instance, a 100% investment in large-cap U.S. stocks achieved an annualized real return of 6.98% or higher in only 38% of the rolling 35-year periods between 1926 and 2014, but in 53% of the rolling five-year periods.
For 30-year holding periods, large-cap U.S. stocks acted a bit more “normal” by producing a real return at or above the long-run return of 6.98% in 57% of the rolling periods.
Small U.S. stocks acted more in accordance with expectations: Of the 35-year periods, 69% produced a real annualized return of at least 8.22%, compared with 58% of the rolling five-year periods. Bonds produced a real return equal to or higher than the long-run return of 2.4% about 44% of the time, regardless of the holding period.
Cash outperformed the long-run real return of 0.53% between 51% and 58% of the time over the various holding periods. A four-asset portfolio produced a real, inflation-adjusted return of 6.61% or higher in 45% of the rolling 35-year periods and in 53% of the rolling five-year periods.
MARGIN OF UNDERPERFORMANCE
Before we lose faith in long-term investing, we need to consider another aspect of this issue — namely the margin of underperformance when an asset class (or portfolio) misses its long-run performance level.
When investing for 35-year periods over the past 89 years, a 100% large-cap stock investment delivered a real annualized return of 6.98% or higher 38% of the time. But this means that, in 62% of the historical 35-year rolling periods, it failed to achieve a return of 6.98%. As shown in the chart “Falling Short” below, it turns out that the average annual performance gap in those periods of underperformance was 77 basis points.
Much more dramatically, when investing for five-year periods, a portfolio consisting only of large U.S. stocks failed to produce a real return of 6.98% in 47% of the rolling five-year periods, but the average amount of underperformance was a whopping 748 bps.
This is a key observation: Short-run returns (like rolling five-year returns) can often exceed the long-run real return. But when they don’t, the performance misses by a lot. When investing over longer time frames, the achieved performance tends to be much closer to the long-run return, even though it may not exceed it quite as often.
Small-cap U.S. stocks produced a real return of 8.22% or higher in 69% of the rolling 35-year periods. But in the 31% of the 35-year periods that they failed to do so, the average performance gap was only 71 bps below the long-run return. In five-year rolling periods when small stocks failed to equal or exceed the long-run return, the average underperformance was a staggering 962 bps.
Investing in a four-asset portfolio for 35-year periods failed to produce a real return of 6.61% in 55% of the periods, but the average performance gap between the achieved real return and the long-run real return was only 57 bps.
Over five-year periods when a four-asset portfolio failed to produce a return of 6.61%, the gap was 516 bps.
We clearly see that longer holding periods produce real returns that are much closer to the real long-run return.
FIXED-INCOME CATEGORIES
For bonds and cash, the performance gap was much more consistent over the various time frames, primarily because the performance of those two asset classes can be characterized by elongated performance cycles that are highly related to movement of interest rates.
Based on the past 89 years, investing in stocks and a diversified portfolio for longer periods does not guarantee inflation-adjusted performance that meets or exceeds the long-run real return, but it does increase the likelihood of achieving performance that is much closer to the long-run return.
Among bonds and cash, we take some comfort in observing that a long investment period is not as crucial in achieving a real return that is reasonably close to the long-run return. For this reason, these two asset classes (particularly cash) are viewed as safer short-term havens, compared with the dramatic performance volatility that we observe in stock-based investments.
But we also observe that the risk of dramatically underperforming the long-run performance of stocks can be significantly reduced by investing in stocks for longer time periods.
Based on these findings, I believe that, for stock and stock-based portfolios, a long-run investment period is at least 25 years. Over that length of time, the likelihood of achieving — or coming close to achieving — a return that approximates the anticipated long-run return is far higher.
Craig L. Israelsen, Ph.D., a Financial Planning contributing writer in Springville, Utah, is an executive in residence in the personal financial planning program at the Woodbury School of Business at Utah Valley University. He is also the developer of the 7Twelve portfolio.
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