As I write this the US stock market is down -2.5% on the day. It’s down about -8.5% from its peak just a few weeks ago. Then again, it’s up 11% over the last year, 38% over three years and 110% over 5 years. This is what the stock market does. Over long periods of time the stock market will go up in value because corporations accrue revenues and profits over long periods of time. In the short-term, however, the stock market is virtually unpredictable. Here’s the probability of positive stock market returns over rolling periods:
In other words, the stock market is a near coin flip over short periods of time, but the further out you go the more predictable it becomes. In fact, over 20 year periods you can be almost 100% certain of the stock market’s returns. But 20 years is a long time and most of us aren’t disciplined to let our assets sit around for 20 years because we live our lives in the present. I often call this our “temporal conundrum”. We all have an inherent asset-liability mismatch in our financial lives because we spend in the present, but we accrue income and asset returns in the long-term. And so the better you can match your income or returns to your expenses the more predictable you can make your financial life.
This is why the stock market is so behaviorally challenging. It’s a long-term instrument that exacerbates that asset-liability mismatch in our lives. When you get scared by a falling stock market it’s because it creates temporal uncertainty. When people sell into bear markets they’re selling the uncertainty of stocks in exchange for the certainty of cash (the shortest instrument of them all). This is what makes diversification such a powerful tool. The investor who buys a 60/40 stock/bond portfolio isn’t just diversifying across assets. They are diversifying across time because they’re blending that 60% of long-term instruments with 40% of shorter-term instruments (aggregate bonds are, on average, about 5-6 year instruments using my Defined Duration methodology). When you mix this you come up with an instrument that’s about 12 years in duration. That’s still pretty long, but it’s shorter than 20 and so it’s more predictable. Of course, you can build multi-asset portfolios many different ways. In our Countercyclical Indexing strategy I like to use a 10 year target duration for the multi-asset index, but the application of that depends on personal preference and planning needs.
But this all brings me back to today because we can’t always afford to only think about 10, 12 or 20 years out. And so we all need some degree of even shorter temporal diversification. If you have an income you have a certain degree of short-term diversification from your job. I like to think of your job or income as a bond allocation. If you make $100,00 per year you could say you have a $1,000,000 (hopefully) inflation adjusted bond that generates 10% per year. If you’re young and that income is secure then you can most likely afford to be very aggressive with your savings portfolio because you already have a form of bonds in your portfolio. You’re temporally diversified by your income. But if you don’t have a job then you need to fill the void somehow to reduce your uncertainty across time. This is also what makes retirement planning so difficult – you effectively lose an asset in your portfolio when your income stops or declines.
And this is why I’ve become such a big advocate of defining our asset durations within our financial plans. I like to keep it simple and think across 5 specific time horizons:
0-2 years – these are your short-term needs dependent on income or inherently short-term instruments like T-Bills or money market funds.
2-5 years – these are your moderately short-term needs and should always be matched to 2 year notes or any multi-asset instrument with a 2-5 year duration.
5-15 years – these are your intermediate needs and are typically best matched with traditional multi-asset instruments like a 60/40 or other multi-asset blends.
15+ years – these are your long-term needs and should be matched to very long-term instruments like stocks.
Uncertain – this is your insurance bucket. It’s there because the unknown happens. It’s best matched to literal insurance (always buy term life insurance to cover a specific term of your life) or if used in a savings portfolio it can be matched to instruments that display insurance like features (typically options, tail risk funds, gold, etc). Some people don’t need this bucket, but it can provide some extra peace of mind if you don’t find your income and 0-2 year bucket to be enough reassurance.
In my experience this process is the very best way to build a behaviorally robust and planning-based portfolio. Not just because it helps you understand your underlying financial plan, but because it helps you navigate your financial needs across time. Personally, I’ve become virtually impervious to stock market downturns because of the way I’ve constructed my portfolio to be diversified across assets and, more importantly, time horizons. Going thru this planning process allowed me to match the scariest assets to very long time horizons and so on days like this I see that my IRA is way down and I just say “who cares, I’m not touching that thing for 20+ years”. At the same time, I have income and other specific assets allocated across shorter time horizons that give me the certainty to ride out any short-term market or economic turbulence. I can “stay the course”, as John Bogle liked to say, because my portfolio is so temporally robust.
If days like today scare you then that probably means you aren’t diversified across time and you hold too many long-term instruments relative to your short-term needs. Or you don’t understand how your portfolio is helping you establish certainty across time. I hope this methodology helps you better understand the importance of temporal diversification in your portfolio and build a more behaviorally robust financial plan.