Investors want to receive the highest possible return with the lowest possible risk. However, the risk/reward trade-off principle says we cannot increase our potential return without increasing our exposure to risk. Is that always true? The risk/reward principle is usually applicable for short-term investments, but when we consider long-term investments, we can maximize potential return with minimal exposure to risk.
Consider the risk/reward principle in comparing a stock portfolio and a bond portfolio. In any one year, an all-stock portfolio has a higher potential return and a higher probability of loss than does an all-bond portfolio. Therefore, stocks are considered the higher risk/reward investment over a short time period. The applicability of the risk/reward principle depends the time horizon considered. When we evaluate the stock portfolio over a longer time horizon, the potential return increases and the probability of loss decreases.
Looking at the past 85 years of historical investment returns, from 1926 through 2010, we can see which time periods an all-stock portfolio performed better and which time periods an all-bond portfolio performed better. Considering all 5-year time periods from 1926 through 2010, stocks performed better than bonds in 70% of the 5-year periods. Considering all 15-year time periods, stocks performed better than bonds in 95% of the 15-year periods. Considering all 25-year time periods, stocks performed better than bonds in 100% of the 25-year periods.
The historical investment return data shows that as we extend the time horizon, the risk of a stock portfolio decreases because the probability of a higher return increases. That should be the focus for long-term investors. Do not worry about the daily volatility of a long-term investment. The ultimate goal of a long-term investment is to maximize return. In time periods of 25 years or longer, an all-stock portfolio has always produced a higher investment return than an all-bond portfolio. So if you are an investor with a long time horizon, investing in a stock portfolio should minimize your risk of inferior performance.
