Do you believe that equity is less risky in the long term? Experts have long debated whether time diversification – in finance-speak, that means equity becomes less risky the longer you hold it – is myth or reality. The debate is yet to settle.

Here, we discuss the relevance of time diversification and how you should invest to meet your life goals.

Relevance Suppose stocks are less risky in the long term. You have to only invest in equity to meet your long-term goals. These are goals that you want to achieve in 10 years’ time or more.

Experts who believe equity is not less risky in the long term base their argument on investment concepts. And those who believe equity is less risky in the long-term depend on past stock market performance to support their viewpoint.

Why is this debate important to you? For one, if equity is indeed less risky in the long-term, you need less investment capital to meet your long-term goals. You will increase your equity allocation as you “know” equity risk will reduce with time. And because equity generates higher returns than bonds, you need less investment capital to achieve your long-term goals.

For another, you need not worry about short-term declines in your equity investments. If equity is less risky in the long term, it means the stock market will bounce back to recover the losses you suffered early on in your investment horizon.

The issues The question is: are you willing to bet on time diversification and increase your equity allocation to meet your long-term goals? And remember, even if the risk decreases with time, your absolute loss can be higher because your portfolio value will increase with time!

Even if equity investment is less risky in the long term, stock prices tend to fluctuate in the short term. Can you withstand the short-term fluctuations in the interest of achieving your long-term goals?

If you are a typical investor, chances are that you will be gripped with fear when you witness such short-term fluctuations. Your emotional mind often imagines that the recent short-term event is more likely to occur in the future. This belief could prompt you to sell your long-term investments based on short-term fluctuations.

Next, consider the technical argument. The short-term fluctuations in stock prices can hurt your long-term goals. Suppose your portfolio has unrealised gains of 25 per cent. It only takes a 20 per cent decline in the market to wipe out the gains in your portfolio.

On the other hand, if your portfolio has unrealised losses of 25 per cent, the stock market has to move up by 33 per cent to recover just your capital!

So even if equity is less risky in the long-term, you have to weather short-term fluctuations in equity investments to achieve your long-term goals.

Conclusion You should make your investment decisions based on the three following points:

One, invest in bonds if your time horizon is 5 years or less.

Two, invest in equity and bonds if your time horizon is more than five years. Reduce your equity allocation as your time horizon draws nearer.

Three, if you are investing to achieve an important life goal, first estimate the minimum amount you need to prevent complete failure of the goal. Then, invest in bonds such that the maturity value equals the minimum amount; invest the rest in equity.

The author is the founder of Navera Consulting. Feedback may be sent to >portfolioideas@thehindu.co.in

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