How do you reduce risk in your investment portfolio? Most people try to do so by diversifying their assets and avoiding stocks when fears are high. But new research indicates the best risk-reducing measure is to buy stocks — and hold them, Marketwatch’s Chuck Jaffe says.
The research, performed by David Blanchett of Morningstar, Michael Finke of Texas Tech University and Wade Pfau of the American College, keys on the notion of “time diversification”, a somewhat controversial idea that
“suggests that the longer holding period effectively diminishes the effect of any short-run period, as has happened to folks who rode out the financial crisis of 2008 by sticking with the market through its ups and downs to get to its recent highs,” Jaffe writes.
“One would think that in theory holding a diversified portfolio of cash, bonds and stocks creates the most amount of wealth 20 years from now,” Blanchett said. “That actually isn’t the case. If you look back over history, holding stocks over the long haul has been the optimal thing to do…and this effect of time diversification has actually been increasing, so the benefits to long-term investors have been growing over the last 110 years, not shrinking, so holding equities is actually a better and better thing to do.”
For an investor with a 20- or 30-year time horizon, “probably the lowest risk long-term investment for that investor is actually stocks,” Blanchett said. “Throughout history, holding a portfolio of all stocks has actually been less risky of all cash, if you look at the final income value after 30 years.” Jaffe notes that the research focused on holding broad market indexes of stocks, not picking and choosing individual equities. The research, which covered 20 countries and over 100 years in those markets, also doesn’t suggest investors give up on diversification in terms of the countries and sizes of companies in which they invest, and doesn’t suggest that investors should ignore personal factors that mean their time horizons must be shorter, he says.
But Jaffe says the research does suggest “that you should overweight your portfolio toward stocks, even as you age and most people are becoming more conservative.”