Feb 24, 2009

The true risk of stocks for the long run (part 2)

This simple model posits that investing in stocks for 30 years is actually more risky than investing in them for only 1 year. This runs counter to most of the standard advice about investing. Yet you can clearly see that the risk of investing in stocks increases with time by looking at the price of insuring your portfolio against losses buy buying put options on the S&P 500 index. The graph below shows the how the cost of such insurance as a percentage of your portfolio increases as you increase the length of time you want protection. But are there other reasons why stocks really are a better investment for the long run?

My coin flipping model assumes that returns follow a binomial distribution. For this to be true, equity returns must follow a random walk. Although I believe they do but this is open to debate. There is some evidence that returns are not random from year to year, but are actually mean-reverting. This occurs when a stochastic process tends to return to its long-term average value. To put it another way – if stocks drop a lot over several years, eventually prices will be so low that investors start buying, and returns move back to the average. It’s a plausible theory, but the mean reversion effect is weak. You can’t earn abnormal profits by buying after the market drops one year or sell short after it rises the following year. For example, after the market has a bad (good) year, it may continue to drop (rise) for the next several years. Even if we accept mean reversion, it may take so long for returns to get back to the average that an investor can’t rely on them to prevent his portfolio from declining over a 10 or 20 year period. If those 20 years occur near your retirement, there may not be time to recover before you are forced to start drawing down your principal.

Another line of reasoning says that an investor has two types of assets in his portfolio: financial capital and human capital. Early in your career, you have a lot of human capital and little financial capital. Over time, you convert your human capital into financial capital through savings. Returns to human capital are considered risk-free. Since the intelligent investor should consider the risk of all assets in his portfolio, young people with a lot of riskless human capital can afford to take more risk with their financial capital, and shift this mix over time. My problem with this argument is that your human capital should not be viewed as a risk-free asset. Skills and education are valuable but not invulnerable from risks such as technological change or substitution by cheaper labor somewhere else in the world. Moreover, your returns to human capital are not completely independent from the overall economy. Unemployment and declines in equity prices are highly correlated, so at the time you are most likely to lose your job (or at the very least, not receive a raise or promotion), stocks are also likely to be down. A counter argument to my proposal says that if stocks prices go down, you can work more years to replenish your portfolio. However, there are many other risks to your human capital such as illness, injury, or family circumstances that could force you to leave the labor force early. I believe that economic security in retirement is just too important to assume that none of these risks will affect you.

1 comment:

Hari said...

Where did you get the charts from?