Risk is a fact of investing. Your willingness to take risk as an investor is a big part of why you can potentially earn returns that exceed what you’ll get for holding cash—this is known as the “equity risk premium.” Still, for some, the idea of investing risk is unnerving. The good news is that there are concrete steps you can take to help control the amount of risk you’re taking with your investments, and one of those is being thoughtful about your time horizon (which is how long you stay invested).
At Wealthfront, we’re big believers in investing as a way of building long-term wealth, but we don’t recommend trying to invest to build wealth in the short term. That’s because financial markets have historically behaved somewhat predictably over the long term, but they’re extremely unpredictable over the short term. In this post, we’ll dig into the relationship between time horizon and probability of loss to help you be a more informed and confident investor.
Don’t take market risk with your short-term savings
First things first: if you expect to need your money in the short term, you probably shouldn’t invest it, especially not in a portfolio containing exposure to stocks. The same goes for your emergency fund. While this type of portfolio can represent a good tradeoff between risk and return over a long period of time (at least 3-5 years), your investment faces a higher likelihood of loss over a short period of time due to market volatility.
Instead, for money you expect to need sooner than 3-5 years from now, we suggest a high-yield cash management account like Wealthfront’s Cash Account, which offers a high APY of 5.00% and up to $8 million of FDIC insurance through our partner banks. This kind of account enables you to earn a competitive interest rate on your short-term cash—until you’re ready to invest—with no market risk, so you don’t have to worry about whether your funds will be available when you need them.
If you want to take on a small amount of risk over a near-term time horizon like 1-3 years, you might look into a product like Wealthfront’s Automated Bond Portfolio, which is made up of bond ETFs and designed to earn a higher yield than a Cash Account with less market risk than a diversified portfolio of equities.
History shows the relationship between probability of loss and time horizon
When you’re saving for the long term (at least 3-5 years but potentially much longer), it usually makes sense to take some market risk so your savings have a chance to grow at a rate that will keep up with inflation. (Again, this is because of the equity risk premium.) And when you do that, you should know that history shows a fairly consistent relationship between investing time horizon and probability of loss, which represents one way you can be thoughtful about the level of risk you’re taking on.
We put together the table below to illustrate the historic relationship between probability of loss and investing time horizon. We analyzed monthly US stock market returns (using the full US total market return series from Ken French’s website, which includes both large and small-cap US stocks) from July 1926 to September 2023, and calculated the total returns during that time period if you had invested for all possible 1-10 year, 15-year, and 20-year periods. We then calculated the percentage of all of those periods with negative total returns to understand the probability of loss.
As you can see, the probability of loss essentially declines with your investment horizon. If you had invested in the entire US stock market for any 1-year period, there would be a roughly 1-in-4 chance that your investments would decline in value by the end of that year. But if you had invested for a 10-year period, those odds drop to less than 1-in-20. And keep in mind that the table above uses pre-tax total return data from the US stock market, which is more volatile (and thus more likely to lose money in any given year) than a well diversified portfolio containing multiple asset classes including fixed income securities, like Wealthfront’s Classic portfolio. You can see the historical performance of Wealthfront’s Classic and Socially Responsible portfolio here to get a better idea of how these diversified portfolios have fared in the past.
One last note on the table above: You might wonder why the 10-year periods have a higher probability of loss than the 8- or 9-year periods in our analysis. The short answer is that, while risk does go down as the time horizon lengthens, the actual probability of loss over 10 years between 1926 and 2023 was a bit higher because of the timing of various crises that affected equity prices. The longer answer is that more of the 10-year periods in our analysis included two crises: namely the dot-com bubble of the late 90s/early 2000s and the 2008 financial crisis. Similarly, some 10-year periods in our analysis included nearly all of the Great Depression from 1929-1939. And while 15- and 20-year time periods were even more likely to include two crises or all of the Great Depression, the time frames were long enough for positive returns to overcome the losses in the period.
Not all investment losses are bad
It’s also worth noting that investment losses, unpleasant as they may seem, can work in your favor if you conduct tax-loss harvesting in your portfolio. Tax-loss harvesting is a strategy historically used by wealthy investors to improve their after-tax returns. It involves selling investments that have declined in value, replacing them with similar investments, and “harvesting” the loss to use at tax time. At Wealthfront, we automate tax-loss harvesting at no additional cost so you can keep more of any potential earnings. This strategy is so powerful that Wealthfront’s Chief Investment Officer Burt Malkiel called it “the only reliable way for investors to outperform the market, as it allows you to do so on an after-tax basis.”
The takeaway: Time is on your side
If you’re an investor, time is generally on your side. History shows that your probability of loss has been lower over longer periods of time, and a longer time horizon also has historically given any potential earnings more time to compound.
We know the idea of getting started with investing can be intimidating, particularly if you’re concerned about losing money. The future is always uncertain, but with a time-tested and research-backed approach to investing (like what Wealthfront uses) and a long time horizon, you can stack the odds in your favor.
The information contained in this communication is provided for general informational purposes only, and should not be construed as investment or tax advice. Nothing in this communication should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. Any links provided to other server sites are offered as a matter of convenience and are not intended to imply that Wealthfront Advisers, Wealthfront Brokerage or any affiliate endorses, sponsors, promotes and/or is affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise.
The analysis above explores the probability of loss for an investor engaged in the US market over various investment periods – specifically 1-10, 15, and 20 years – based on historical data from 1926 to 2023. The data used includes the total US market returns, accounting for reinvested dividends, as sourced from Ken French’s database. The monthly returns span from July 1926 to September 2023.
To assess the probability of loss over different investment durations (N years), we employed a rolling return methodology. This involved calculating the total returns for consecutive N-year periods starting from 1926 to 2023. For instance, for 2-year returns, we analyzed periods such as July 1926-June 1928, followed by August 1926-July 1928, and so on up to October 2021-September 2023. The probability of loss was then determined by the proportion of these periods that yielded negative total returns. This analysis does not factor in potential tax implications or investment fees. Past performance is not indicative of future results. Investors should consider their individual circumstances before making investment decisions.
All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. Historical returns, expected returns, and probability projections are provided for informational and illustrative purposes, and may not reflect actual future performance. Please see our Full Disclosure for important details.
Investment management and advisory services are provided by Wealthfront Advisers LLC (“Wealthfront Advisers”), an SEC-registered investment adviser, and brokerage related products, including the cash account, are provided by Wealthfront Brokerage LLC, a Member of FINRA/SIPC.
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About the author(s)
Fang Rui is a Chartered Financial Analyst (CFA) and an investment researcher at Wealthfront. Prior to Wealthfront, Fang spent nearly a decade at BlackRock where she worked in ETF and index research as well as risk management. She earned a Master of Science in Industrial Engineering and Operations Research from University of California, Berkeley and earned a Bachelor of Science in Engineering with a major in Operations Research and Financial Engineering from Princeton University. View all posts by Fang Rui, CFA