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Wednesday, April 13, 2005

How Long Is A Long-Term Investment? Longer Than You May Think

An interesting and important article in the Economic Review , First Quarter 2005, Vol. 90, No. 1, published by the Federal Reserve Bank of Kansas City:

How Long is a Long-Term Investment?By Pu Shen

Conventional wisdom tells us that stocks tend to outperform government bonds in the long term. That is, if stocks are held long enough, they are usually better investments because their total return is likely to be higher than the return on bonds. While this view may be correct in principle, in practice a crucial question remains: How long is long enough?

The answer is important to every investor, not just the wealthy few. With employers relying increasingly on defined-contribution retirement plans, employees must make their own saving and investment decisions.

Shen reviews historical patterns to show investors how the riskiness of stocks and bonds can change as an investor’s holding period lengthens. First, she explains why stocks are generally considered riskier than government bonds and thus, on average, should pay higher rates of return to attract investors. She then shows why stocks, with their higher average rates of return, tend to perform better over sufficiently long holding periods. Next, she examines the historical patterns of stock and bond returns in the United States. She shows that sufficiently long has been very long relative to most people’s holding periods. Finally, she examines various holding periods in detail. She finds that, for many investors whose holding periods were not sufficiently long, risks for both stocks and bonds were quite high. She concludes that, historically, longer holding periods may have reduced the riskiness of stock investments but not bond investments. Further, for most individual investors, feasible holding periods have seldom been long enough to take full advantage of long-term stock investments.

What does this seem to mean? It suggests that the time horizon required to feel confident that returns to stock ownership will actually exceed returns to bond ownership are longer than the (economic) lifetimes of many--or most--investors. I leave the implications of this for replacing part or all of Social Security with stocks as retirement savings as an exercise for the reader.


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