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Is Your Long-Term Investment Horizon Long Enough?

Tips for extending your time horizon.

Bridget B. Hughes, 06/17/2008

My son turned nine the other day, and my husband remarked, "Well, he's halfway there."

It was only yesterday that he was born! In the blink of an eye, he's covered a lot of ground--walking, baseball, report cards--and now he thinks he ready for his own iPod! (He's not.) He'll be as tall as I am in no time and through junior high faster than I can say, "Slow down." College is right around the corner, and I know the next nine years are going to go by just like that.

I think we can all agree--time flies.

So if nine years goes by lickety-split, why are we impatient when it comes to our mutual funds? Recent data from the Investment Company Institute suggest that on average, a mutual fund is held for roughly four to five years. While that's longer than I would have guessed, it hardly qualifies as "long-term investing."

Instant Gratification 
Whether it be a piece of pie, a new car, or investment returns, as consumers, we want it now. And in some sense, the financial industry is giving it to us. Mutual funds are priced daily, telling us that we have a gain or loss for that day, month, year, and so on. And plenty of cable channels and internet sites, including Morningstar.com, give us reams of information in seconds. But the fact that we can make hair trigger reactions to market events doesn't mean we should.

Investors aren't the only ones. Portfolio managers are arguably as susceptible to some short-sightedness. Turnover rates across mutual fund categories suggest a time horizon well shorter than five years. The median large-blend fund, for example, shows a turnover rate of 40%, which indicates a time horizon of roughly 2.5 years. While turnover numbers aren't perfect measures of holding periods, our conversations with portfolio managers shed some additional light: Even the longer-term-oriented ones tend to look out only three to five years when making their initial investments.

Time Is on Your Side
At the risk of stating the obvious, the market is cyclical--and unpredictable. Some cycles are longer than others; some are more volatile. But we do know that over the very long term, large-cap stocks, for example, have returned around 10% per year on average, according to market researcher Ibbotson. A look at historical rolling returns is also informative: Since early 1970, the S&P 500 Index has posted a one-year return smaller than that long-range historical average roughly 40% of the time, including losses roughly 20% of the time. When you extend your time horizon, however, losses are less frequent. Looking back over rolling 10-year periods since 1980, the smallest annualized return is, at least, a gain (3.5%).

What's more, many investors' goals are long-term in nature--retirement arguably being the most important and daunting. At 38, I have a 401(k) account that I don't plan to touch for at least 21 years. Even my son's college account has a longer duration than that of the average mutual fund holding period (though changes to its makeup need to come as college approaches).

A Better Way
I'm not suggesting that you invest in a mutual fund, then plunge your head in the sand. Information can be incredibly useful, and there are legitimate reasons for selling funds after a shorter period of time. Following are some suggestions, though, to help keep you grounded, particularly when your mutual fund seems in a funk.

Write down why you're buying a fund and save it.
Get at the fund's fundamentals here. Be sure to include your thoughts on things like its basic strategy, management, and other resources. How does the fund fit in your portfolio, and how much does it cost? Comment on whether you trust the fund firm. Try to avoid citing past performance, particularly short-term, as your main reason for buying the fund.

Fundamentals change less frequently than relative returns, so basing your choice on a fund's basic attributes, what's behind returns, will result in a more-solid and confident decision. When things get hairy--and they will from time to time, even at the best funds--retrieve your list. If the fundamentals haven't changed, stand pat.

Set expectations.
I'm not talking numbers here, but think about how the fund has behaved in the past or how its strategy is supposed to work. Does it hold up better in market downturns, or does it soar in happier markets?

When gauging performance, be specific. If you want to figure out how a fund will hold up in weak markets, for example, consider the market between March 2000 and October 2002 or mid-July 2007 and early March 2008.

Be careful when looking at "trailing" returns, which have an end date on the day prior to whichever day you decide to look at them, particularly if they are shorter than 10 years. Remember market cycles vary in duration, and even a five-year number may not capture a full one.

Once you've got a handle on the fund's performance drivers and characteristics--and you've been honest about your own risk tolerance, you'll better understand and tolerate its future returns.

Bridget B. Hughes is a senior fund analyst with Morningstar.

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