The Fallacy of Time Diversification

Written By Brian Schreiner

The following is an exerpt from my upcomming book: Wall Street Snake Oil: The Myth of Passive Investing.

Paul Samuelson is one of the most influential economists in history. He won the Nobel Prize in Economics in 1970 and aggressively combated the traditional Wall Street dogma that stocks become safer the longer you hold them.

In his 1963 paper,  “Risk and Uncertainty: A Fallacy of Large Numbers,” he mathematically dismantled this concept, known today as time diversification. Most investors and financial professionals confuse two very different metrics: average annual returns and terminal wealth.

The Illusion: It is true that as time passes, the probability of underperforming cash or experiencing a negative average annualized return shrinks.

The Reality: You do not buy groceries with percentages; you buy them with absolute dollars. Over a 30-year horizon, the variance (uncertainty) of your final net worth grows exponentially. 

While the odds of losing money drop, the magnitude of a potential loss in the worst-case scenario increases severely. A single market crash right before you retire can wipe out decades of accumulated compounding gains—this is the "devastating loss" Samuelson warns against.

Modern portfolio theory depends primarily on the false premise of time diversification—the idea that the longer you own stocks, the safer your portfolio. Wall Street has built an entire industry around this fallacy and it’s the reason that every target-date 2060 fund holds more stocks than every target-date 2040 fund.

Every major stock market in the world has declined by 70% or more at least once and have had multiple declines of 50% or more. The risk of catastrophic loss does not decrease with time; it increases. Common sense confirms this. Think about driving your car. Does the risk of having an accident increase or decrease with time behind the wheel?

Wall Street does not care about your true risk tolerance. If they did, your advisor would explain that, over time, the risk of your portfolio being impacted by a severe market crash increases. Instead, he tells you it decreases, because that’s what he’s been taught.

You understand intuitively that active portfolio management can reduce risk by tactically shifting portfolio holdings. Using the car analogy, you know that the less you drive, the lower the probability that you will crash. During periods when stock prices are overvalued, it makes sense to actively shift allocations to less risky investments. For investors who value risk management, active management and diversification to uncorrelated asset classes offer benefits passive strategies can’t provide.

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Some interesting things I came across this week…

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Off the beaten path...

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This commentary reflects the personal opinions, viewpoints and analyses of the Alpha Rock Investments, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Alpha Rock Investments, LLC or performance returns of any Alpha Rock Investments, LLC client. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Alpha Rock Investments, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

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Brian Schreiner
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