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Question:


What is time diversification regarding investing? What are the benefits?
-JoseGS


Answer:


Time diversification refers to the belief that stocks are always better investments for the long run because their returns are higher and the long lag will nullify the impact of greater volatility that stocks generally exhibit. If the stock market plunges and you're young enough, the thinking goes, you can hang tough and wait for it to recover.
 
The pro-time diversification camp also points out that annualized returns for stocks - how big any movement would be if it occurred at the same rate for a year - tends to show less variability the longer the study period is. On any given day, the market can go up or down a couple of percent, which would be a massive move if extrapolated out for a full year. The annualized return over the course of any decade, by contrast, will be much closer to the return of any other decade.
 
The anti side would respond that it's wrong to ignore the cumulative effect of price movements and that time diversification doesn't take into account that with the higher returns of stocks and a longer time horizon come a much greater range of possible portfolio values. Take two $10,000 stock portfolios held for 30 years, one earning 7 percent a year and the other earning 10 percent. It may not seem like that big a difference, but the first one would grow to about $87,000 and the second one would be worth $228,000.
 
The snappy retort of the pro-time diversification side would be that no matter how gaping the range of potential returns, they are bound to be higher in stocks than bonds. Perhaps the best solution for investors is to follow the conventional wisdom and invest heavily in stocks and move gradually more into bonds as they get older.
 
To give yourself a greater edge, rebalance once or twice a year. Sell a portion of either stocks or bonds - whichever has risen the most - and add to your holdings of the other if there has been a significant change in value, say 5 or 10 percentage points. If you want to keep 70 percent in stocks and 30 percent in bonds, for instance, and the mix goes to 60/40 after a bad year for stocks, sell some bonds and put more in stocks to restore the balance to 70/30. That will allow you to follow another piece of conventional wisdom: Buy low, sell high.

-Conrad de Aenlle



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