LESS THAN THREE YEARS after the past bear market, it's certainly understandable that some investors still can't get over their fear of losing money in the stock market. They seem to view equities as an anxious game of Russian roulette: The longer they stay in, the greater their chance of experiencing more losses. In fact, history shows that the opposite is true. The easiest way to reduce the risk of investing in equities — and improve the gain — is to increase the time you hang on to your portfolio.
See for yourself. The demonstration below uses historical data from 1950 through 2005 to compare investment returns over different lengths of time for small-cap stocks, large-caps, long-term bonds and T-bills.
The graph starts out showing results for investments held over one-year periods. There's no doubt about it: Over such short intervals, small-cap stocks are definitely the riskiest bet. Sure, you could double your money, but you could also lose nearly 50% in a single year. Compare that with 20-year Treasury bonds — during their worst year, they were down only about 15%.
But what about investing for more than a year? If you move the slider at the bottom right of the graph, you can see the range of returns for longer time periods. Even investing for two years instead of one cuts your risk significantly. As the length of time increases, the volatility of equities decreases sharply — so much so that you may need to click the "zoom in" button to get a closer view. Over 10-year periods, government bonds look safer than large-cap equities on the downside. Click the "adjust for inflation" box, however, and you'll see that bond "safety" can be illusory. Inflation has an uncanny ability to erode the value of securities that don't grow fast enough.
Now move the slider all the way to right to see the results of investing for 20-year intervals. Adjusting for inflation, the best 20-year gain a portfolio of long-term Treasury bonds could muster was much lower than that achieved by small- and large-cap stocks. And contrary to popular belief, over their worst 20-year period, long-term bonds actually lost when adjusted for inflation. Meanwhile, small-cap investors still had gains over a 20-year-period, even when stocks were at their worst.
Source: CRSP, Federal Reserve
Of course, this doesn't mean you're guaranteed to make money buying small-cap stocks. The statistics we've cited are market averages and reflect the range of returns you'd expect from an index fund, rather than a portfolio of just a few individual holdings. And although the numbers show that it's a good idea to stay in the market as long as possible, they say nothing about how long you should hang on to particular stocks or funds. The overall lesson, however, is simple: The stock market delivers its cruelest blows to those who cash out too early.