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From Wall Street to Washington

The Good, the Bad, and the Mean

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Nicholas Barberis, associate professor of finance

The Good, the Bad, and the Mean
Investing for the Long Run

Financial advisers often maintain that long-term investors allocate more aggressively to equities. But according to research by Nicholas Barberis, associate professor of finance, investors would be wise to hedge their bets.

Financial advisers today generally suggest that long-term investors aggressively allocate assets to stocks. If you follow a human capital argument, for example, younger people should invest more in stocks than should older people. Human capital is an individual's future wage earnings - a very important asset - and many economists think of these fixed annual wages as bonds. So if younger people already have a sizeable position in bonds through their human capital, they should counterbalance this with a heavy financial investment in stocks.

Then there is the mean reversion rationale, which says that historically, bull markets have generally been followed by bear markets, and vice versa. As stock market fluctuations offset each other over time, it makes sense for younger investors to put more into stocks than bonds. Even if the stock market were to crash, there would be a high likelihood that losses for younger investors could be recovered over the long term.

"There's this popular advice that people who have many years left to live should put more of their money into stocks. Because there's some mean reversion in stocks, in the long run, they're not that risky," said Nicholas Barberis, associate professor of finance.

Barberis analyzed the validity of this advice in his paper "Investing for the Long Run When Returns Are Predictable." Though he concluded that young investors should indeed invest more heavily in stocks than should older investors, the effect is not as large as many people think. The reason, he warns, is that "the evidence of cycles in the stock market is actually very weak."

With such tenuous evidence that the stock market reverts to the mean after huge upswings or downswings, Barberis believes that many advisers may be encouraging investors to hold overly aggressive positions in equities.

Calculating Long-Run Risk
According to Barberis, the statistical evidence for mean reversion consists of two data points. The stock market went up in the 1920s and down in the 1930s, then up in the 1950s and 1960s and down in the 1970s.

In conducting his own research, Barberis used monthly data spanning 523 months, from June 1952 to December 1995. The stock index he employed was the value-weighted index of stocks traded on the New York Stock Exchange (NYSE), as calculated by the Center for Research in Security Prices (CRSP) at the University of Chicago. In calculating excess returns, Barberis used U.S. treasury bill returns provided by Ibbotson Associates.

"Our analysis shows that sensible portfolio allocations for short- and long-term investors can be different in the context of predictable returns," Barberis wrote. Mean reversion in returns lowers the variance of long-horizon returns. "This makes equities appear less risky at long horizons, and hence, more attractive to the investor," said Barberis.

But when he looked at the actual historical data on asset returns, Barberis found that the true extent of mean reversion in returns was fairly small. Long-term investment in the stock market is still sound advice, according to Barberis, but the mean reversion rationale behind it is not as powerful as many people think. "I found that people with a 20-year horizon would want to put 15 percent more into stocks than people with a one-year horizon, which is a lot less aggressive than some advisers recommend," said Barberis.


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