Time Diversification: Perspectives from Option Pricing Theory

Despite repeated theoretical arguments to the contrary, many investment professionals subscribe to the principle of time diversification. This principle states that equity investments become less risky if held for longer periods of time. We apply option pricing theory to the question of how the investment horizon affects equity risk. Financially engineered securities that guarantee a minimum return allow for greater equity market participation if the investor commits to a longer time horizon. In other words, the fair cost of insuring a minimum return, in terms of foregone market participation, is lower for longer horizons. The lower cost of risk reduction suggests that risk itself is lower, consistent with the pervasive practitioner belief in time diversification.