Wednesday, December 17, 2008

Know Your Investment Horizon

Market volatility since October 2007 has cause some individuals to question whether equity ownership is an appropriate investment vehicle. In fact, most major benchmarks are mirroring their values from 10 years ago. The last 15 months has reminded many close to retirement that equities can drastically decrease in value from time to time, and such a decline can have a severe effect on a retirement plan.

For those entering the retirement stage of their lives, I apologize, but this article is not for you. Hopefully, this market pull back has encouraged you to closely examine your tolerance for risk, and develop a portfolio that is properly diversified and appropriately allocates assets between cash, bonds, and stocks.

For those with 7 years or more before retirement, listen up. Nearly one hundred years of market data suggest that the market will return an average of 10% over time. Clearly, as the last decade has illustrated, it may take time for the law of averages to take effect, but ultimately, we have always been able to count on 10% returns in the long run. Consequently, I would argue that for individuals with a long investment horizon, now is a perfect time to invest in stocks. Think of today's market condition in terms of a chart: We know that over time, market returns are going to be a positively sloped line that increases in value over time. The longer market returns are insignificant or even negative, the larger the gap between actual returns and historical returns. The larger the gap, the more gain stocks will ultimately need to achieve to catch up to historical norms. Thus, the larger the gap, the more inexpensive stocks appear to be.

Expanding on this idea, let's picture an ideal situation for a 40 year old individual with 25 years until retirement. The best thing that could happen for this individual is for stocks to not provide any gain, or even decline in value until the day he retires. If stocks stayed the same price for 25 years, that individual could continue to collect assets at a cost that is inexpensive compared to the historical price trend line. Ideally, after collecting as many assets as possible at this price, the value of these stocks would shoot straight up in order to catch up to the historical trend line the day this individual retires.

Of course, this situation would never actually occur, but hopefully it illustrates how poor market performance can be a blessing for those who are years away from needing their invested funds. Clearly, there is currently a gap between the market's actual performance and the historical trend line of market performance. People with the appropriate investment horizon should take advantage of the market sell off and allow time for the law of averages to bolster market returns back to where past market performance indicates values should be.

Visit a fee only CFP with a fiduciary responsibility to do what is in the best interest of their clients to start taking advantage of these favorable investment conditions.

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