Time Diversification: Fact or Fallacy? Historical, Theoretical and Empirical Analysis.

9 Chapter 1 THE TIME DIVERSIFICATION CONTROVERSY 1.1) The Time Diversification In the Portfolio Management industry and theory there are different concepts and models which are well recognized across professionals and academics: the Markowitz model and the reduction of risk through diversification are two examples of broadly acknowledged pillars of the Asset Management industry. On the contrary, other beliefs and points of view are source for discussion and contrasts; one of these is Time Diversification. The debate is not a recent matter: it’s more than 30 years that the Time Diversification controversy fills up in the academic and practitioner world. All the time diversification arguments can be extracted from the following statement: “Over the long run, the asset allocation for an inv estor should shift higher weights to risky assets like equities because above-average returns tend to offset below-average returns”1. Following this statement, investors with a long holding period (10 or more years) would have to invest the greater part of their savings in risky assets because the final wealth which they can obtain will be surely higher than the wealth resulting from the investments in risk free assets. The debate shows a clear separation between people who is in favor of time diversification, and consequently with the overweight of equities in a portfolio made for the long run, and people who is against the time diversification, meaning that, despite the long holding period, investors should not tilt its portfolios into equities hoping in a secure outperformance respect a more prudent asset allocation. At one side, we find the practitioners which believe in the time diversification and advise their clients to increment the part of portfolio invested in risky assets. Their argument in favor of time diversification is mostly the verdict of history: the U.S. stock market returned on the last 200 years, despite the cataclysmic stock crash of 1929 and the more recent explosion of the technology bubble, 6.84% for year, while short term government bond returned only 2.91%, expressed in real terms. In numbers, it means that one dollar invested in equities in 1801 would have carried at 31st December 2003 the impressive amount of about 8.80 millions $ in nominal terms (about 600,000 $ in real terms), while the same dollar invested in T-bills, the short term U.S. government bonds, would have become only less than 4,500 $ (304 $ in real terms). 1 Mark Kritzman, What practitioners need to know…about time diversification, Financial Analysts Journal (January- February 1994), p.14-18