Why Stocks Are Risky for Long-Term Investing


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The Wrong Advice? Financial advisors traditionally
recommended stocks for long-term investing, but
stocks are more volatile in the long run than the
short run, according to research by Lubos Pastor.

Holding equities long term mitigates the risk of investing in the stock market, according to conventional investment wisdom. But stocks are riskier than generally perceived, according to Lubos Pastor, whose research shows that long-horizon stock investors actually face more volatility than short-horizon investors.


Stocks have always been considered a great choice for long-term investing. The inherent risk, while always present, is countered by an investor’s holding the stock for many years—advice given by financial advisors for decades. But academics who back the claim have been looking at stock performance retroactively—a distorted lens, according to Lubos Pastor, Charles P. McQuaid Professor of Finance.

In “Are Stocks Really Less Volatile in the Long Run?” Pastor argues that stocks are riskier than generally perceived. With coauthor Robert Stambaugh of the University of Pennsylvania, he uses a different measure of volatility—not historical but forward-looking, which matters more to investors, Pastor told Investment News.

“Historical volatility is somewhat relevant to investors, but it does not fully capture all the uncertainties that investors face,” he said. “For example, the historical-average stock market return may have been, say, 10 percent per year, but there is no guarantee that the average return in the future will also be 10 percent. In fact, it will almost surely be different.”

Since uncertainty about this future average compounds over time, its effect on volatility increases with the investment horizon, Pastor added; this uncertainty makes stocks more volatile in the long run than in the short run.

The paper identifies five components of long-term volatility of stocks, including the variance obtained if stocks followed a random walk, which is the same regardless of the length of the investment, and “mean reversion” in stock returns, or the fact that bull markets tend to be followed by bear markets and vice versa, which is the basis for the conventional wisdom.

But the researchers note three additional components of variance that pull in the opposite direction, each reflecting various types of uncertainty faced by an investor. For instance, an investor does not know what the average stock market return is going to be in the future. In addition, the investor does not know what the equity premium is today, or what the other parameters of the return process are. “All of these quantities must be estimated, leaving the investor with substantial estimation risk, and all get bigger as the investment horizon lengthens,” Pastor said. “Their combined effect outweighs that of mean reversion. As a result, forward-looking investors perceive stocks to be more volatile in the long run.”

The economic downturn has been devastating for those investors who are retired or are near retirement. But are investors under age 40 wrong to believe they can make up the loss over the decades remaining until they retire? Yes and no, Pastor said. “Investors who believe that their depressed stock investments are guaranteed to rise at historical rates in the long run may well be mistaken. But youngsters do have an advantage over older investors in that they have more time to adjust their consumption patterns over their lifetimes.”—P.H.

 

Last Updated 5/14/09