Many investors give little thought to setting a realistic time horizon over which they hope to achieve a targeted return on investment.
A targeted six per cent total annual return over a period of 10 years might be a realistic objective for a well-diversified portfolio comprised of 70 per cent equities and 30 per cent fixed income. On the other hand, if that were the investor’s objective over a brief period of only two to three years, it would be imprudent. In the latter case, the investor would be ignoring the short-term volatility inherent in equity investments. Over the shorter term, the investor might strike gold, but equally possible, would be a big loss.
For most investors in equity markets, a minimum investment time horizon of five years is advisable. Even that could prove too short.
An example: Over the five-year period ending Aug. 31, the TSX Index delivered an annualized total return of only 1.3 per cent. On the other hand, over the 10-year period to the end of August, the annualized total return was a sizzling 8.1 per cent. This 10-year pattern of excellent performance for equities holds true for virtually any decade over the past 60 years.
Aside from the need to ensure a long-term investment time horizon, what do these facts teach us? Principally, to take great care in our initial investment choices, and then, to stay invested. Trying to time the market by selling and buying, in hopes of benefitting from normal market swings over shorter-term periods, is a losing proposition. If the experts can’t predict market swings with any more than random chance, the average investor is likely to lose out big time.
If an investor’s time horizon must be less than five years, it is best to dramatically reduce exposure to equity markets and to increase fixed-income holdings, such as GICs, Bonds, Bond Funds and possibly Preferred shares.
This historic pattern of short-term equity market volatility, outweighed by excellent long-term performance, is precisely why the younger investor can benefit from holding primarily equity-based investments. On the other hand, as retirement approaches, equity-market volatility needs to be moderated by holding a greater proportion of fixed income.
The retired investor, relying on a monthly withdrawal of substantial funds from the portfolio, needs to be particularly mindful of the heightened risk of equity volatility. The best hedge? An even a greater proportion of fixed-income holdings. Some equity participation is usually advisable for a retiree, in order to preserve some capital appreciation, and to protect against inflation.
The overriding lesson? Equity investing is primarily about careful initial selection, combined with a long-term view. The gambler may celebrate the occasional win, but over the long-term, he is most likely to lose.