Summary 

In our previous house view Asset Allocation and the Power of Time (I) - Market Timing, we delved into the intricate world of market timing and why achieving perfection in this endeavor remains an elusive quest. Today, we continue our exploration by shedding light on the pivotal role played by the time horizon in shaping asset allocations.

• Fixed-income instruments provide a deterministic yield, albeit vulnerable to inflationary degradation over the long haul. Conversely, equity investments offer long-term capital appreciation but with amplified short-term volatility. Given equal expected returns, rational investors will gravitate towards the asset with reduced volatility.
• Time horizons significantly impact asset allocation. To accumulate and grow wealth in the long run while accounting for inflation, equity exposure is imperative. Extending the investment horizon can mitigate equities' inherent short-term volatility, fostering compounded returns and outperforming fixed-income securities. Hence, the investor's investment horizon primarily dictates asset allocation.

Interest-generating & Equity Investments

The historical tableau of a portfolio's performance reveals itself as intricately entwined with the dance between corporate bonds and large-cap equities. Interest-generating investments primarily hold an advantage in that the income stream can be determined in advance, yet these investments are susceptible to erosion by inflation. Interest-generating investments do not simultaneously offer income streams and maintain purchasing power. On the other hand, equity investments provide returns through dividends and capital appreciation, making them conducive to genuine long-term inflation-adjusted capital growth, with the principal disadvantage being elevated short-term volatility.

Interest-yielding and equity investments delineate the distinction between "lenders" and "owners". Lower returns are the cost "lenders" pay for the benefit of predictability, while short-term volatility is the price "owners" pay for potential long-term capital growth associated with equity.

While equity investments have the potential to yield superior returns, the prevailing apprehension among individuals towards the market's inherent volatility surpasses their concerns about inflation. Consequently, many prefer to embrace the relatively modest returns offered by bonds, aiming to safeguard the stability of their principal. Unfortunately, this tendency often leads them to overlook the insidious and erosive effects of inflation on their wealth. Several factors contribute to this phenomenon:

1. While the impact of inflation is subtle in the short-term, over the long run, the erosion of purchasing power due to inflation is significant. Assuming a future inflation rate of 3%, the purchasing power of $1,000 will decrease to $744 in 10 years, to $554 in 20 years, and to $412 in 30 years.

2. Investors often perceive their investment results in nominal terms. For instance, in 1979 and 1980, when the inflation rate peaked at 12% to 13%, the returns on government bonds reached historic highs of 10% to 11%. Yet, in reality, in the lower interest rate environment of the '90s, the actual returns for government bond investors significantly outpaced the high-interest-rate environment of 1979 and 1980.

3. Short-term stock volatility can potentially cause more harm than inflation. For example, on October 19, 1987, large-cap equity prices plummeted by more than 20% in a single day, while the highest annual inflation rate of the past half-century was 13% in 1979. The impact of a massive short-term loss is more directly perceptible.

Looking to the future, we can be certain of two things. First, , the unpredictability and volatility of short-term equity returns will persist. Second, human nature dictates a preference for predictability over uncertainty. Consider, for example, a choice between two investment options: Investment A has an expected return of 8% with a standard deviation of 2%, while Investment B offers an expected return of 8% with a standard deviation of 4%. Even with equivalent expected returns, Investment B's volatility is twice that of Investment A. Rational investors are averse to volatility and, faced with this choice, most investors would opt for Investment A, demonstrating a lack of incentive to take on the heightened volatility risk of Investment B.‍

Time Horizon

Time serves as one of the pivotal elements in the sphere of investment management. Its function in determining applicability unfolds when we appraise investment strategies. If we consider an investor, cognizant of an impending need of $50,000 to procure an automobile in the ensuing month, their inclination towards a money market fund becomes a rational investment selection. However, this specificity of requirement is absent in most extended investment situations. The more prevalent aim here is to safeguard and amass wealth despite the presence of inflation, mandating the indispensable engagement of equity investments.

While the oscillations of stocks in the near term may be perceived as exorbitantly large relative to anticipated yields, this dynamic undergoes an evolution with time. To illustrate, from the span of 1926 to 2005, large company stocks outstripped bonds in 51 out of the 80 years, thus holding a superior stance for 64% of the time. However, a longitudinal comparison spanning holding periods of 5, 10, and 20 years manifests that these large-cap stocks outflanked bonds 78%, 86%, and 100% of the time respectively.

Over the passage of time, the projected returns from stocks maintain constancy. However, as the duration of holdings extends, the fluctuations in compounded returns diminish significantly. This principle mirrors the concept of asset diversification. The rationale behind this lies in the increased likelihood over an elongated holding period for prosperous years to offset those that are less fruitful, thus significantly narrowing the range of compounded annual returns. If we perceive the volatility of the stock market as a malaise, then time would be its antidote.

The enchantment of compound interest also leaves its imprint on the longitudinal growth of large-cap stocks. A 6% equity risk premium can be the catalyst for significant disparities in wealth accumulation over an extended duration, considering a situation where government bonds currently yield 4% and the estimated annualized compounded return rate for large-cap stocks stands at 10%. Under these circumstances, in a span of just 13 years, the forecasted cumulative wealth from investments in large-cap stocks would be twice that of corresponding investments in bonds. By the 20-year mark, the valuation of large-cap stocks would triple the investments in government bonds. In essence, while volatility might mask the projected returns from stocks in the short term, in the long view, stocks triumph due to higher average returns, a converging path of return growth, and the marvel of compounding. From the viewpoint of asset allocation, time is the crucial variable to strike the right balance between interest-bearing investments and equity investments within a portfolio.

Departing Notes

In investment management, the true opportunity to achieve stellar outcomes doesn't reside in the sprint to outpace the market, but rather in the construction and steadfast adherence to suitable, long-term investment strategies. Such strategies are designed to leverage the portfolio to benefit from the central, long-term dynamics within the market.  

As we move forward, our subsequent series will continue to delve into the indispensability of asset diversification, gleaned from historical data. We also aim to share the steps involved in the creation of a comprehensive asset allocation framework and how we tackle some of the challenges encountered in real-world scenarios.

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