Stocks, Bonds, And The Investment Horizon: Decision-making For The Long Run by Haim Levy

Chapter 1
 Asset Allocation and the Horizon: The
 Ongoing Disputes
 Anyone seeking investment advice from professional investment
 consultants has probably faced the following first question: “For how long
 do you wish to invest?” This question indicates that the length of the
 investment horizon, at least from the practitioners’ point of view, is an
 important ingredient needed in order to give the best investment advice to
 clients. Thus, the investment horizon is considered by practitioners as
 necessary information to establish the optimal asset allocation between
 risky and less risky assets, generally classified as stocks and bonds,
 respectively. Moreover, it seems that most investment consultants, albeit not
 all of them, believe that there is a connection between the length of the
 planned investment horizon and the desired asset allocation.1 Specifically,
 the usual investment advice is that the longer the planned investment
 horizon, the larger the investment weight that should be allocated to risky
 assets (stocks) — not because investors like risk, but because they expect to
 obtain a reward, namely to realize a relatively large rate of return on the
 investment in stocks. Thus, the common view among practitioners is that by
 investing in stocks rather than in bonds, the advantage of a relatively large
 reward outweighs the disadvantage of a relatively large risk, as long as the
 investment horizon is relatively long. The common rule of thumb, which is
 consistent with the “stocks for the long run” investment strategy, is that
 investors should allocate 100% less their age to stocks.

Notwithstanding, there is empirical evidence that allegedly contradicts
 the “stocks for the long run” strategy. Specifically, although the planned
 investment horizon may be very long, say, saving for retirement, it is
 empirically observed that, in practice, the investor typically changes their
 portfolio mix or the mutual funds held after a relatively short period,
 typically one year. Thus, there is a gap between the “planned” investment
 horizon, that may be very long, and the “actual” investment horizon, that is
 typically about one year. The difference between these two horizon
 concepts is discussed in the next section.
 1.1. The “Planned” and the “Actual” Investment Horizons
 As the investment horizon is the central issue discussed in this book, we
 first elaborate on the difference between the planned investment horizon
 and the actual investment horizon. It is important to contrast these horizons,
 as they are relevant for investment decision-making. The optimal asset
 allocation, the performance indices, and the asset’s risk measures, among
 other things, are all a function of the investment horizon. Thus, the
 important question is: what is the relevant horizon, the planned or the actual
 horizon, to be employed in measuring and analyzing all the above economic
 issues, particularly the optimal asset allocation that is of crucial importance
 for virtually all investment decisions?
 To illustrate these two horizon concepts, suppose that a young person at
 age 25 wishes to invest for retirement for 40 years. If all economic and
 personal factors remain unchanged, the planned investment horizon may be
 equal to the actual investment horizon, that is, the investor will not change
 the portfolio with time. However, in reality, many things change
 economically (a recession, economic prosperity, the interest rate, inflation, a
 pandemic, and so forth) or in specific personal conditions (being fired
 versus getting another and more rewarding job). Hence, the investor who
 plans to invest for 40 years may change the investment strategy after a short
 period, say, one year, as a consequence of changes in the above conditions.
 The horizon where changes in the investment policy take place as a result of
 changes in the above-mentioned conditions is the actual investment
 horizon, which is generally much shorter than the planned investment
 horizon. Thus, we may find empirically that while the planned investment

Stocks, Bonds, And The Investment Horizon: Decision-making For The Long Run by Haim Levy