Investment Horizon
Yesterday’s post discussed how the classic advice of “start thy purse to fattening” from “The Richest Man In Babylon” can be best applied in today’s world.
For the rest of the week, we’ll focus on two other gems from that little book:
- Make thy gold multiply
- Guard thy treasures from loss
And the best place to start is with understanding the importance of investment horizon.
Returns and volatility
Like most other things in life, greater risk generally leads to greater reward. But it also leads to greater volatility because risky endeavors frequently go wrong (sometimes badly so).
Thus, more risky investments can give much higher returns than safe investments, but they can fluctuate wildly over time.
Time as a risk mitigation strategy
The stock market offers a classic example. History says that well-diversified stock market investments will, on average, double in value every decade – truly amazing returns.
However, if you invest your money in stocks today, there’s a good chance that your investment will actually lose value in the next month or the next year.
Here, it’s key to understand that you can only lose money in the stock market when you sell for a lower price than you bought. If your shares go down in value, you lose nothing until you sell.
Hence, the only real risk to stock market investment arises when you need cash so badly that you have to sell your stocks at a time when your investment has lost value.
This is the key risk we can mitigate by understanding the concept of investment horizon.
Investment horizon
With each passing year, the likelihood that your investment will be worth less than its original purchase price diminishes.
As illustrated in this linked article, even if you had the worst timing in history, you would have made at least a moderate return in stocks after 15 years. For perspective, the best timing in history would have increased the value of your investment by 15x over the same period! In reality, you’ll fall somewhere between these extremes.
The aforementioned article also repeats this exercise for various other asset classes, showing that the point with essentially zero risk of losing money comes a lot earlier with secure investments like government bonds, but the long-term returns are smaller.
Low-risk stock market investments
This leads us to a pretty striking conclusion:
If you ensure that you’ll never need the money you invested in stocks so desperately that you will be forced to sell at a loss, the risk of stock market investment is close to zero.
If your investment loses value, just stay calm and do nothing. After a year or two, the stock market will always bounce back.
Tomorrow, we’ll look a little more closely at these low-risk, high-return, long-term investments.