Long term is the magic bullet for risk

Many investors are looking for a magic bullet that will reduce the risk in their portfolios without affecting return.

Regrettably, until such time as the laws of nature are repealed, there are only two time-tested ways to reduce risk while maintaining returns.

One way is through more sophisticated portfolio construction - going back to the 1950s, the pioneering work on diversification by Nobel-laureate Harry Markowitz has led to extensive advances on mixing investments to optimize risk and return. In fact, in some cases better portfolio construction can both reduce risk and increase return.

The other approach to reduce risk without decreasing return is to extend the time frame for which risky investments such as stocks are held.

START WITH LONG-TERM RETURNS

Any discussion of a portfolio has to begin with each individual investor's needs for appreciation and income to hit their long-term goal - this will yield their target rate of return.

A good place to go next is to look at after-inflation returns for different investments for the 84 years from 1926 (as far back as we have really good data) to the end of 2009.

We can compare large-cap U.S. stocks to intermediate, five-year government bonds and T-bills. Note that we should focus on real, after-inflation returns - what really matters when investing for retirement.

Even after the past couple of years, after inflation stocks have returned three times bonds and 10 times T-bills.

For someone investing $100,000 in stocks, the after-inflation appreciation of about $259,000 is almost five times that in bonds and almost 20 times the gain in T-bills, which just barely beat inflation.

THE ODDS OF LOSING MONEY

The downside to stocks is that you'll lose money about three in 10 years and periodically you will lose more than 20 per cent in a calendar year. Even worse, twice these 20 per cent declines occurred two years in a row.

In the 84 years since 1926, stocks have lost 20 per cent or more eight times after inflation - so about one in 10 years.

Three of those were in the 1930s, then in 1946, in 1973 and 1974 and most recently in 2002 and 2008.

There is good news for longer-term investors, however. Looking at three-year periods reduces the chances of losing stocks to about one in four.

In 10-year time frames, investors lost money 12 per cent of the time - based on the experience since 1926, you have to go out to 20 years to completely eliminate the chances of losing money in stocks.

Understanding the impact of time frame

For many people, the best way to understand the impact of time frame on returns is to see this visually. Recently, I worked with Michael Nairne and his team at Tacita Capital to convert data from Morningstar's EnCorr database using the Ibbotson SBBI Large Company Stock index into three charts, showing returns over one, three and 10 years.

The first chart shows one-year returns - it has extreme spikes; if this were all that investing in stocks entailed, most investors would bail out right there.

The next chart shows rolling three-year returns, still a bit of a roller coaster, but less so.

The third chart shows rolling average returns for 10 years; by the time you get to 10 years, you see a level of volatility that is still more than many Canadians would like but also a level that most can live with.

The good news is that the longer your holding period, the less you experience sharp drops - the extreme ups and downs disappear and the tops and the bottoms on returns get cut off.

Based on everything we've experienced historically, holding stocks for longer periods of time is the only way to truly reduce the risk of owning them - as hard as that might be at times.

And in fact, the case can be made that if investors aren't prepared to hold stocks for an extended period of time, they shouldn't buy them in the first place.