The Risk of the Unknown: A New Perspective on Equities

The objective of these viewpoints is to question commonly accepted pillars of financial advice.  So I took notice when Consuelo Mack interviewed Lubos Pastor, Professor of Finance at the University of Chicago.  Pastor recently completed research stating that stocks become more risky over longer investment horizons.  His research takes the investor point of view (i.e. forward looking and accounting for uncertainty) rather than a historical (i.e. backward looking) point of view.  Furthermore, he suggests that the 7% annualized real return stocks experienced during the last century–based on Jeremy Siegel’s analysis–is uncommonly high with several lucky events bolstering that figure.  Pastor’s final pearl of wisdom suggests that human capital should play a significant role in portfolio construction.

Here is the abstract from his forthcoming paper, “Are Stocks Really Less Volatile in the Long Run?”:

According to conventional wisdom, annualized volatility of stock returns is lower over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor’s perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties reduce desired stock allocations of long-horizon investors contemplating target-date funds.

Essentially, as uncertainty about future outcomes increases, the potential for higher volatility increases–the assumption is that distant-future is more uncertain than near-future.  Volatility can be one measure of risk, but it is certainly not the only measure.  So then, why is increased volatility inherently more risky?  Consider two situations with the same outcome, where two portfolios return 7% over the course of a year, but the path for the second return is much more volatile than the first.

The reason high volatility is riskier is due to investor behavior.  That is, the behavioral risk increases!  How will you handle the volatility during the course of the year?  You’re not a buy-and-hold investor anymore.  Your portfolio isn’t driven solely by a quantitative model.  Your emotions are a factor–and they are a negative influence at that.  Morningstar tracks the difference between fund returns and investor returns; the average investor never outperforms the fund that they are invested in.  That is, the majority of investors’ timing is terrible (i.e. they buy high and sell low). These are the realities.

The solution is to reduce behavioral risk.  Become a buy-and-hold investor, use quantitative models, or construct your portfolio to produce fairly consistent returns.  Of those three options, I recommend the latter for the retail investor.  Pastor’s comments regarding human capital were also intriguing, but perhaps I will discuss that in a future post.  You can find Pastor’s interview at WealthTrack.

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  • Mstatman


    Thanks for quoting my book, What Investors Really Want. I hope that you enjoy reading the rest of it.

    Meir Statman