Why Time Horizon Works
You might have heard that people these days are getting all worked up about P/E multiples. Morgan Housel comes to their rescue with this succinct but powerful piece on P/E multiples. First he simplifies investing to just two variables:
“Two things drive markets over time:
- Earnings, including dividends.
- Changes in how much investors are willing to pay for those earnings (valuation multiples).
That’s it. Every movement – short or long term – is a function of one of those two things.
And a few important details about these two things:
- Earnings tend to accrue and compound over time in a way that makes their growth reasonably predictable in a diversified portfolio, because populations grow and workers get more productive.
- Changes in valuations are wildly unpredictable because they mostly reflect shifts in public moods. But, importantly, they don’t compound over time. The P/E ratio falling from 20 to 18 will have the same percentage impact on market prices whether it happens in 2019 or 2049.”
Then he explains (and this explanation includes an outstanding chart you should click on the link and see for yourself) that: “When earnings compound but changes in valuation multiples don’t, the importance of the latter to your lifetime returns diminishes over time…Valuation changes have a majority impact on your overall returns early on because company earnings are likely the same or marginally higher than when you made the investment. But as earnings compound over time, changes in any given year’s valuation multiples have less impact on the returns earned since you began investing. So as time goes on you have less reliance on unpredictable things (voting) and more on things you’re confident in (weighing).”