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The long term in the stock market is a lot longer than you probably think. A whole lot longer.
In fact, according to new research, it’s exactly 41.22 years.
It’s hard to overestimate the significance of this finding. While almost all of us pay lip service to the importance of being a long-term investor, few of us ever focus on why: The length of time we need to hold an equity portfolio so that we don’t care about bear markets along the way.
Absent that long of a holding period, in other words, we really do need to care.
Even fewer of us ever try to quantify the long term. But in practice our investment horizons are laughably short. The joke on Wall Street is that the long term lasts from lunch until dinner.
The study that came up with this new definition of the long term is titled “Inferring Stock Duration Around FOMC Surprises: Estimates and Implications.” It appeared in the March issue of the Journal of Financial and Quantitative Analysis and was conducted by Zhanhui Chen, a finance professor at the Hong Kong University of Science and Technology.
Chen used a novel approach to determine the length of the long term, calculating the stock market’s duration. Most of us are familiar with duration as a property of bonds, with a longer-duration bond being riskier. But the author of this new research contends that it’s possible to calculate a functionally equivalent duration statistic for the stock market.
To appreciate what Chen found, it’s helpful to review what duration means in the bond market: A bond’s sensitivity to interest-rate fluctuations. For example, a bond with a duration of five years would be expected to lose 5% if interest rates rose 1%. A bond with a 10-year duration would be expected to lose 10%.
This formulaic approach to bond duration is not wrong. But, conceptually, a bond’s duration is the holding period required for an investor to be indifferent to price fluctuations along the way. Think of a 10-year Treasury note, for example: If I’m willing to hold it for 10 years, I don’t care what happens to interest rates during that 10-year period.
Chen uses a similar logic for deriving this “point of indifference” for stock market investors. He analyzes the market’s immediate reactions following Federal Reserve’s interest-rate announcements, zeroing in on the stock market’s true sensitivity to rate changes.
Armed with that sensitivity, he can derive what the stock market’s duration must also be. The implication of this new research: Since few of us operate with a 41-year investment horizon, we can’t really be indifferent to bear markets in stocks.
That means that, for most of us, we can’t be confident that holding through thick and thin is the right course of action — notwithstanding assurances from financial planners to the contrary.
Sobering as Chen’s findings are for our retirement portfolios, I suspect at some deep intuitive level we know that he’s right. There’s something too good to be true in the standard financial-planning narrative that stock market risk goes down as holding period lengthens — but returns do not.
There’s an element of magical thinking in believing that we can reduce risk without also forfeiting return in the process.
In light of this new research, you may still want to maintain just as high an equity allocation as before. But at least now you’ll know that the returns you earn are fair compensation for the bear market risk you incur along the way.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
