How Long Is a Long-Term Investment?

Federal Reserve Bank of Kansas City - Economic Review, First Quarter 2005 by Shen, Pu

In other words, it may not be wise to believe that the required holding periods for stocks to outperform inflation 100 percent of the time in coming decades will be exactly as in the past-namely, 24 years. Instead, it may be better to assume that the required holding periods will be in a range around 24 years. For example, if the range is plus or minus five years, then in the future stocks may beat inflation 100 percent of the time for holding periods of as short as 19 years, or as long as 29 years. Similarly, for stocks to outperform bonds 100 percent of the time in the next half century, it may be more likely that a holding period of a minimum of 21 to 31 years is needed.23

Given that the historical pattern may not be repeated in the future and that the ideal holding periods are too long for many investors, it may be fruitful to examine the historical performance of stocks and bonds over selected holding periods. This section does so for holding horizons of ten years, 20 years, and 25 years. It also discusses how changes in inflation and the fiscal outlook, as well as a few special factors, might have affected past performance.

Holding periods of ten years

For investors with holding periods of ten years, historically the real returns on stocks were positive about 89 percent of the time, compared to only 68 percent for holding periods of one year (Chart 2). While on average investors had an annualized real rate of return of 6.6 percent, the average masked some very poor performing periods. Stocks did not keep up with inflation after ten years 11 percent of the time. In the worst-case scenario, an investor could diligently add $1 every month to the broad stock market index, reinvest all the dividends in the index for ten years, and end up with only 56 cents on the dollar, adjusted for inflation. In other words, in the worst case the cumulative real return was -44 percent.

While bonds are generally considered less risky over short horizons, they were no less risky compared to stocks at the ten-year horizon. Historically, bond investors with holding periods of ten years beat inflation only 53 percent of the time, compared with 60 percent of the time for investors with holding periods of one year. Even though the average annualized real rate of return was 2.4 percent, nearly half of the time bond investors did not break even. In the worst-case scenario, bond investors lost a cumulative 41 percent for the ten-year period-nearly as much as the unluckiest stock investors.

A direct comparison of stocks and bonds does not yield a clear winner, however. While stocks had a higher average rate of return than bonds, they could still underperform bonds over ten-year periods. In fact, historically, stocks offered lower returns than bonds roughly 12 percent of the time (Chart 4). In the worst case, the value of a stock portfolio was 31 percent less than a bond portfolio (Chart 5).

Holding periods of 20 years

For investors with holding periods as long as 20 years, stocks were a bit less risky. After 20 years of repeated investment, stocks beat inflation about 98 percent of the time. Over the 2 percent of the time when the real return on stock investments was negative, the worst loss was a cumulative 13 percent. Bond investors, in contrast, were able to beat inflation only 40 percent of the time. Over the other 60 percent of the time, their real returns were negative, and the worst loss was 48 percent (Charts 2 and 3). For holding periods of 20 years, stocks historically outperformed bonds 99 percent of the time (Chart 4). Over the other 1 percent of the time, stock portfolios underperformed bonds, sometimes by as much as 15 percent (Chart 5).