Do you believe stocks are safer the longer they are held?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.

Do you believe stocks risk diminishes with time?

Yes
46
38%
No
76
62%
 
Total votes: 122

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rmelvey
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Do you believe stocks are safer the longer they are held?

Post by rmelvey »

Most of the leading academics in finance argue that risk does not diminish with time. Paul Samuelson has written dozens of articles on this, and Zvi Bodie and Robert Merton are now carrying the torch attempting to spread the word with little avail.

I see tons of posts saying that "I have a long time horizon so I can take a lot of risk" on this forum. So there appears to be a disagreement, or at the very least a misunderstanding of the theory of risk and return.

Personally, the idea of risk diminishing with time makes little sense to me. If it were true, corporations would simply issue zero coupon bonds, load up on stock indices, and arbitrage away the free lunch offered by time. Finance is all about bridging the gap between the patient and the impatient, so the idea of a free lunch existing over time is extremely suspect to me.

Where do you stand on this issue?
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Re: Do you believe stocks are safer the longer they are held

Post by mhc »

I don't have an answer for your poll because I don't know. I suspect there will be a discussion on what is risk.

Just because a person says he has a long time horizon so he will go all in on equities does not necessarily mean that he believes equity risk diminishes with time. If one has a long time horizon, certain steps can be taken to offset the risks associated with equities if they happen to materialize (e.g., get a second job, spend less, marry rich).
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Re: Do you believe stocks are safer the longer they are held

Post by Wagnerjb »

rmelvey wrote:Most of the leading academics in finance argue that risk does not diminish with time. Paul Samuelson has written dozens of articles on this, and Zvi Bodie and Robert Merton are now carrying the torch attempting to spread the word with little avail.

I see tons of posts saying that "I have a long time horizon so I can take a lot of risk" on this forum. So there appears to be a disagreement, or at the very least a misunderstanding of the theory of risk and return.

Personally, the idea of risk diminishing with time makes little sense to me. If it were true, corporations would simply issue zero coupon bonds, load up on stock indices, and arbitrage away the free lunch offered by time. Finance is all about bridging the gap between the patient and the impatient, so the idea of a free lunch existing over time is extremely suspect to me.

Where do you stand on this issue?
It is all in how you define risk. If you define risk as "the likelihood that stocks will underperform bonds", then historically the "risk" of stocks has diminished with time. If your alternative investment is bonds, then I would think this risk is pretty important to a long-term investor.

If you define risk as the variability of long-term cumulative returns, then yes stocks are riskier with time. But investors don't care about the "risk" of stocks wildly outperforming. They don't care if stocks return a sub-par risk premium as long as they beat bonds. They only care about the "risk" that represents stocks underperforming bonds. And over time that risk is diminishing.

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Re: Do you believe stocks are safer the longer they are held

Post by Call_Me_Op »

This is a misunderstood statement, Stocks are only 'safer" in terms of the probability you will lose money compared to the value on the day you invested. The probability of losing money (or however else you choose to define risk) relative to any present time t is theoretically a constant.
Last edited by Call_Me_Op on Mon May 06, 2013 12:27 pm, edited 1 time in total.
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Re: Do you believe stocks are safer the longer they are held

Post by livesoft »

I do not believe that stocks are safer the longer they are held.

I do believe that if I invest in stocks over the long term, then I will eventually have larger gains, so that my portfolio will be larger, so that if the risk in stocks shows up that I will still have more money than I started with.
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Re: Do you believe stocks are safer the longer they are held

Post by CyberBob »

It depends on ones definition of risk.
The chances of the market having a negative year this year certainly isn't affected by whether you've been investing for days or decades. But, as time goes by you're more likely to have a better return from stocks than from money under your mattress.

Bob
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Re: Do you believe stocks are safer the longer they are held

Post by plannerman »

I believe I have a much higher probbility of achieving my longer term financial goals by investing the majority of my assets in stocks rather than bonds.

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Re: Do you believe stocks are safer the longer they are held

Post by MathWizard »

Assuming safety can be measured as a fuction of a time interval, the only other options are

1) Stocks are safer the shorter time they are held

2) Stocks are equally safe/unsafe no matter what the time interval.

3) No way to know.


I have a hard time believing 1).

Do the people voting NO mean 2) or do they mean 1 ?

I believe that there is a Return to the Mean behavior which is growth in value iover the
long term due to improvements in technology. (We don't dig basements by hand like my
grandfather did. We travel by car or airplane rather than by horse.)

Stock prices vary due to differing expectation of the amount of growth, the person believing
in the highest grwoth rates for a specific stock by from those who expect a lower growth rate, or who
are trading to get into another even better growth stock.
The person who holds over the long term gets a total return of
A) what the actual growth was
B) plus any premium at the time of sale due to future growth expectations
C) minus any premium paid at the time of purchase

So even if you pay double what the true price should have been at the beginning and only get half the price at the end
(truly horrible performance pricewise) and the sum of the dividends + growth was at a pace of 6% real annually, then
the company's actual growth over the 24 years quadrupled, so over 24 years, even with the terrible price endpoints,
you would come out even.

For the market as a whole, other than of the crash of '29, I cannot imagine a worse outcome than the market being
doubly overvalued at the beginning, and undervalued by 50% at the end.
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Re: Do you believe stocks are safer the longer they are held

Post by bobcat2 »

Risk has two dimensions. There is both the probability of a bad outcome and the magnitude of a bad outcome. The longer the holding period for stocks the higher the probability that they will achieve close to their high expected return, but what also increases with time is the small chance of a really awful cumulative return for stocks. These two dimensions of risk would tend to approximately cancel out if we knew that stocks' expected return was their true mean return. Since we don't know that ex ante, stocks are somewhat riskier over long investment horizons.

Here are Gene Fama and Ken French commenting on how stocks become riskier over long investment horizons.
In particular, we don't know the true expected returns on portfolios. We typically use historical average returns to estimate expected returns, but the estimates are quite noisy, and they leave lots of uncertainty about true expected returns. The uncertainty about expected returns is an additional unavoidable risk of investing. ...

In short, if we knew the true expected return, our uncertainty about long-run returns would grow with the return horizon. But we do not know the true expected return. Because we make the same error when we forecast the one-year return one year out, two years out, and N years out, our uncertainty about long-run returns grows more quickly than the return horizon. ...

Although the uncertainty about the true unexpected return grows linearly with the number of years - the N-year variance is just N times the one year variance - the uncertainty caused by our estimation error of the mean grows with the square of the number of years; the uncertainty over two years is four times our uncertainty over one year.
Link to Fama-French discussion of long-run risk of stocks
http://www.dimensional.com/famafrench/2 ... g-run.html

Bogleheads thread where this topic was discussed and then over discussed. :wink:
http://www.bogleheads.org/forum/viewtop ... 10&t=57903

Perhaps economist Arnold Kling has the pithiest take on this issue.
There is a popular conception that stocks are less risky in the long run than in the short run. This cannot possibly be correct. As Zvi Bodie points out, any option pricing model would break down if stocks were less risky in the long run than in the short run. I notice that the popular conception that stocks are less risky in the long run is rarely challenged by professional economists. Either they do not know any better, or they are not willing to play the skunk at the party.
:D :D

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Re: Do you believe stocks are safer the longer they are held

Post by assumer »

This thread and its associated images / content will be of interest: http://www.bogleheads.org/forum/viewtop ... 0&t=111633
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Re: Do you believe stocks are safer the longer they are held

Post by richard »

bobcat2 wrote:Risk has two dimensions. There is both the probability of a bad outcome and the magnitude of a bad outcome. The longer the holding period for stocks the higher the probability that they will achieve close to their high expected return, but what also increases with time is the small chance of a really awful cumulative return for stocks. These two dimensions of risk would tend to approximately cancel out if we knew that stocks' expected return was their true mean return. Since we don't know that ex ante, stocks are somewhat riskier over long investment horizons.
How do you know that the longer the holding period the higher the probability that stocks will achieve close to their high expected return?

We might be able to make this statement about the past, but how do you know it is true about the future?

What is the "high expected return" of stocks - what number? To the extent we don't know the number (which your post suggests), what does it mean to say "The longer the holding period for stocks the higher the probability that they will achieve close to their high expected return"? The statement seems to mean the longer you hold stocks, the higher the probability they will return an amount equal to a number we don't know. This is a rather difficult proposition to test.

As an aside, my standard objection to "expected return" - it means probability weighted outcome, not most likely outcome (so the expected return can be a highly unlikely outcome). Given that we don't know the probabilities, the notion of a probability weighted outcome is another concept that is difficult to test.
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Re: Do you believe stocks are safer the longer they are held

Post by bobcat2 »

richard wrote:
bobcat2 wrote:Risk has two dimensions. There is both the probability of a bad outcome and the magnitude of a bad outcome. The longer the holding period for stocks the higher the probability that they will achieve close to their high expected return, but what also increases with time is the small chance of a really awful cumulative return for stocks. These two dimensions of risk would tend to approximately cancel out if we knew that stocks' expected return was their true mean return. Since we don't know that ex ante, stocks are somewhat riskier over long investment horizons.
How do you know that the longer the holding period the higher the probability that stocks will achieve close to their high expected return?

We might be able to make this statement about the past, but how do you know it is true about the future?

What is the "high expected return" of stocks - what number? To the extent we don't know the number (which your post suggests), what does it mean to say "The longer the holding period for stocks the higher the probability that they will achieve close to their high expected return"? The statement seems to mean the longer you hold stocks, the higher the probability they will return an amount equal to a number we don't know. This is a rather difficult proposition to test.

As an aside, my standard objection to "expected return" - it means probability weighted outcome, not most likely outcome (so the expected return can be a highly unlikely outcome). Given that we don't know the probabilities, the notion of a probability weighted outcome is another concept that is difficult to test.
Yes our estimate of the future mean return may be in error. That was the point I was making. If we knew the "true" future mean return of equities then investing in equities would involve roughly the same amount of risk regardless of the holding period, because we would be closing in on the mean return over time, but the cumulative dispersion of returns would be increasing. But we don't know that, so investing in stocks becomes somewhat riskier the longer the holding period. Many people appear to assume that their expected return for stocks is the "true" mean return going forward. It is not, it is an estimate, and the fact that it is an estimate means they are underestimating the amount of risk entailed in investing in equities over the long-run.

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Re: Do you believe stocks are safer the longer they are held

Post by nisiprius »

Among others, in 1979 Paul Samuelson wrote Why We Should Not Make Mean Log of Wealth Big Though Years to Act Are Long
Know that life is not a game with net stake of one when you beat your twin, and with net stake of nought when you do not. A win of ten is not the same as a win of two. Nor is a loss of two the same as a loss of three. How much you win by counts. How much you lose by counts.
He demolishes the idea of risk declining with holding time, and closes:
No need to say more. I've made my point. And, save for the last word, have done so in prose of but one syllable.
A tour-de-force, but unfortunately using words of one syllable doesn't actually make it easy to understand.

Here is another.... OK, proof.... that stocks do not become safer the longer they are held. If this were true, then Glassman and Hassett's book Dow 36,000 would have been correct. Their prediction was mathematically based on what they called "undeniable historic facts."
The truth is that, over the long-term, stocks are no more risky than bonds or Treasury bills... soon, prices will rise to where they will be 'perfectly reasonable'—around 36,000 on the Dow Jones industrial average... The Dow 36,000 theory depends on the risk premium for stocks disappearing.... A sensible target date for Dow 36,000 is early 2005, but it could be reached much earlier.
The fact that the Dow did not reach 36,000 by early 2005 proves that over the long term stocks are too more risky than bonds or Treasury bills.
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Re: Do you believe stocks are safer the longer they are held

Post by nisiprius »

MathWizard wrote:I believe that there is a Return to the Mean behavior ...
A lot of people believe this, but even Siegel admits that it is just empirical observation and it has no particular explanation.

If you read Mandelbrot's The [Mis]behavor of Markets, he makes the point that there are perfectly plausible distributions that actually have no mean, or standard deviation, or any higher moments. They can't revert to the mean because there's no mean to revert to. The tails are so fat that no matter how long you keep measuring, you keep getting extreme events that are so extreme that they literally overpowers everything that has come before. No, he doesn't say markets actually behaves that badly; he says they behave somewhere in between that awful behavior and the much-too-tame behavior that... the people who brought us 2008-2009 seem to believe in.

It always amazes me when I read some idiot saying that Goldman Sachs was brought down by "a 25-sigma event." Given the choice between believing they encountered luck so bad that it would happen only once in a few quadrillion universe-lifetimes, and believing that their risk models were wrong... they simply cannot accept the possibility that their models were wrong. It's easier for them to believe the universe went out of its course to do in Goldman Sachs than to believe their models were wrong.
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Re: Do you believe stocks are safer the longer they are held

Post by bengal22 »

I believe that individual stocks are not safer the longer they are held.

I believe that mutual funds with stocks in a diversified portfolio have less fluctuation over time.
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Re: Do you believe stocks are safer the longer they are held

Post by tadamsmar »

nisiprius wrote:Among others, in 1979 Paul Samuelson wrote Why We Should Not Make Mean Log of Wealth Big Though Years to Act Are Long
Know that life is not a game with net stake of one when you beat your twin, and with net stake of nought when you do not. A win of ten is not the same as a win of two. Nor is a loss of two the same as a loss of three. How much you win by counts. How much you lose by counts.
He demolishes the idea of risk declining with holding time, and closes:
No need to say more. I've made my point. And, save for the last word, have done so in prose of but one syllable.
A tour-de-force, but unfortunately using words of one syllable doesn't actually make it easy to understand.
Samuelson is not a fan of repeated optimal bets using the Kelly criterion. Under the Kelly criterion, your wealth grows over time on average and while your chance of a N% loss remains constant.
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Re: Do you believe stocks are safer the longer they are held

Post by Random Musings »

No. One example would be if one held the market from 1926 to the bubble top in 2000. At 2000, they were not safe.

If the definition of "being safe" is that it is the best asset class to hold in the long run for future purchasing power, I would tend to agree with that. But even there, I would want complete world-wide diversification. Think Japan and others......

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Re: Do you believe stocks are safer the longer they are held

Post by HornedToad »

I would rather lose 50% of a really big number than 15% of a small number.

What matters is what the final number is after both the higher growth and higher loss potential from stocks vs. bonds.
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Re: Do you believe stocks are safer the longer they are held

Post by Tortoise »

rmelvey wrote:I see tons of posts saying that "I have a long time horizon so I can take a lot of risk" on this forum. So there appears to be a disagreement, or at the very least a misunderstanding of the theory of risk and return.
Seems to me that people who say this are talking about having a long time to recover from possibly large losses. It has nothing to do with thinking that risk changes over time.
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Re: Do you believe stocks are safer the longer they are held

Post by Clearly_Irrational »

nisiprius wrote:It always amazes me when I read some idiot saying that Goldman Sachs was brought down by "a 25-sigma event." Given the choice between believing they encountered luck so bad that it would happen only once in a few quadrillion universe-lifetimes, and believing that their risk models were wrong... they simply cannot accept the possibility that their models were wrong. It's easier for them to believe the universe went out of its course to do in Goldman Sachs than to believe their models were wrong.
I have to agree. We already know for sure that the market has fatter tails that the normal distribution would suggest. I'm not sure I agree that it can't be modeled but it's certain that their model wasn't correct.
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Re: Do you believe stocks are safer the longer they are held

Post by SpaceCommander »

As others have noted, I think it all depends on how you define "risk". What is "safe"?

If I purchase a blue chip stock with a 4% yield, in 12 years I've recouped half of my original investment in cash. By year 24 or 25, I've received 100% of my principal back. So, yeah, in that case, the longer you hold the stock, the lower the risk of a negative return. Over the years it takes a greater and greater market wipeout to reduce your total return to less than zero. Of course, that's a simplistic scenario with a few debatable assumptions, but you get the basic idea. It's all in how you look at it, and in how you define "risk".
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Re: Do you believe stocks are safer the longer they are held

Post by bobcat2 »

Tortoise wrote:
rmelvey wrote:I see tons of posts saying that "I have a long time horizon so I can take a lot of risk" on this forum. So there appears to be a disagreement, or at the very least a misunderstanding of the theory of risk and return.
Seems to me that people who say this are talking about having a long time to recover from possibly large losses. It has nothing to do with thinking that risk changes over time.
The people who say that will not only have a long time to recover from large losses; they will also have a long time to possibly suffer additional large losses. :(

BobK
Last edited by bobcat2 on Mon May 06, 2013 7:01 pm, edited 1 time in total.
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Re: Do you believe stocks are safer the longer they are held

Post by Peter Foley »

Wagnerjb wrote
It is all in how you define risk. If you define risk as "the likelihood that stocks will underperform bonds", then historically the "risk" of stocks has diminished with time. If your alternative investment is bonds, then I would think this risk is pretty important to a long-term investor.

If you define risk as the variability of long-term cumulative returns, then yes stocks are riskier with time. But investors don't care about the "risk" of stocks wildly outperforming. They don't care if stocks return a sub-par risk premium as long as they beat bonds. They only care about the "risk" that represents stocks underperforming bonds. And over time that risk is diminishing.
This is as close to my opinion as I have read on this thread. Terms need to be defined. We are talking about investing (obviously) and should be defining "stocks" as a broad based low cost mutual fund. There are two risks in investing, market return and inflation. Long term, 30 + years, the return on stocks has been higher than the return on bonds and inflation. This is not necessarily true for 5 year and 10 year periods historically.

The question distorts this as it could mean 2 years are safer than 1, 5 years are safer than 2, etc.
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Re: Do you believe stocks are safer the longer they are held

Post by mrspremise »

I think when people say "I have a long time horizon so I can take a lot of risk" they usually mean they don't plan to access the money for a long time. There is a low risk they will be "forced" to pull out money during a downturn because the money is require for expenses and/or forced to push back a near planned retirement because they were too heavily in equities and had unlucky timing. It doesn't mean that they think the portfolio can't suddenly drop when they are close to retirement, but chances are they have eased into a more conservative position by then. They have to option of not transitioning their AA as they may have originally planned during an strong downturn like 2008. It also might mean it's early enough that they have little enough invested that swings don't panic them as much, and they can stay true to their AA during difficult times. I started my career in 2005 saving heavily and hardly batted an eye in 2008, but those I know close to retirement were worried.
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Re: Do you believe stocks are safer the longer they are held

Post by bobcat2 »

Peter Foley writes.
Long term, 30 + years, the return on stocks has been higher than the return on bonds and inflation. This is not necessarily true for 5 year and 10 year periods historically.
It is hardly a secret that that it is not true that stocks always outperform bonds for periods of 30 years or more. It was all over the financial news in 2011 that LT bonds had outperformed stocks for thirty years. And, as Larry Swedroe points out, LT bonds outperformed stocks for 40 years from 1969-2008. In addition bonds have outperformed stocks over 30 year periods or more in many other countries over the last 100 years - sometimes by a significant amount.

Links -
http://www.bloomberg.com/news/2011-10-3 ... ntury.html

http://www.cbsnews.com/8301-505123_162- ... s-so-what/

Does all this mean I expect bonds to outperform stocks over the next 30 years? No - I definitely don't expect that, but it is possible. What bothers me the most about this is that when bonds outperform stocks over long time periods it is usually because stocks have had poor long-run returns, not because bonds have had particularly great LR returns. :(

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Re: Do you believe stocks are safer the longer they are held

Post by Peter Foley »

Bobcat2
I agree that there are 30 year time periods where stock do not do as well. This does not, however, refute the Trinity Study which shows that in the past (not the future mind you) a portfolio containing more stocks than bonds has a higher probability of success over 30 year periods based on a 4% withdrawal rate. The portfolio with the lowest probability for success was a 100% bond portfolio.

Choosing 2008 as the end period for a long term comparative analysis of relative returns is certainly cherry picking a time period to "prove" one's point.

Edited once for spelling. :(
Last edited by Peter Foley on Mon May 06, 2013 10:20 pm, edited 1 time in total.
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Re: Do you believe stocks are safer the longer they are held

Post by dumbmoney »

Much of the risk with stocks is that you will eventually have to sell, and the relationship between price and 'fundamental value' fluctuates over a wide range. But I don't want to make too much of this, because there's a simpler and more important point.

Investing 100% of a $1 portfolio in stocks is quite safe - worst case, you only lose $1. Point is, risk is better measured in dollars than percentages. Young people can "take more risk" because they are not, in fact, taking more risk.
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Re: Do you believe stocks are safer the longer they are held

Post by baw703916 »

bobcat2 wrote: Perhaps economist Arnold Kling has the pithiest take on this issue.
There is a popular conception that stocks are less risky in the long run than in the short run. This cannot possibly be correct. As Zvi Bodie points out, any option pricing model would break down if stocks were less risky in the long run than in the short run. I notice that the popular conception that stocks are less risky in the long run is rarely challenged by professional economists. Either they do not know any better, or they are not willing to play the skunk at the party.
:D :D

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Hi Bob,

Do options exist for the time periods for which it makes sense to hold equities? The longest ones I've ever seen are 2-3 years. I'm pretty sure that if a poster on this board asking where she should invest money earmarked for a house down payment in 2-3 years, the board recommendation would not be for equities.

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Re: Do you believe stocks are safer the longer they are held

Post by stlutz »

I think when people say "I have a long time horizon so I can take a lot of risk" they usually mean they don't plan to access the money for a long time. There is a low risk they will be "forced" to pull out money during a downturn because the money is require for expenses and/or forced to push back a near planned retirement because they were too heavily in equities and had unlucky timing. It doesn't mean that they think the portfolio can't suddenly drop when they are close to retirement, but chances are they have eased into a more conservative position by then.
Very well stated!

To add a couple of thoughts:

1) With stocks, much of the risk comes with the investor more than investment. Lots of people claim to have a high risk tolerance/a long time horizon etc., but then find out differently when where is a significant market decline and sell when the market is down. As such, the short-term fluctuations are always a risk, regardless of your expected holding period.

2) With this discussion, one's views of how much risk there is and what the expected return are are inversely related. If you think that stocks going down and staying down for 30 years is a very realistic scenario, then your return expectations must be lower; if you think that the 30 years ending 2011 (where stocks actually did just fine; just not quite as good as 30 year bonds) is what stock market risk looks like, then you're return expectations will be much higher. This decision about what your expectations are may have a big impact on your asset allocation, but shouldn't overshadow point #1.



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Re: Do you believe stocks are safer the longer they are held

Post by TylerS »

Yes. I think it's safer to invest for the long term than to bet it all on tomorrow's returns, for example, as I think the long term is safer. There is a significant chance the market is negative tomorrow, where the chance it's negative over the next 20 years is very low.
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Re: Do you believe stocks are safer the longer they are held

Post by saurabhec »

nisiprius wrote:
It always amazes me when I read some idiot saying that Goldman Sachs was brought down by "a 25-sigma event." Given the choice between believing they encountered luck so bad that it would happen only once in a few quadrillion universe-lifetimes, and believing that their risk models were wrong... they simply cannot accept the possibility that their models were wrong. It's easier for them to believe the universe went out of its course to do in Goldman Sachs than to believe their models were wrong.
Did you mean Lehman or Bear instead of Goldman? Goldman Sachs never went bankrupt nor was it at risk of doing so. They were much smarter than many of their peers and were relatively neutral or net short the mortgage market.
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Re: Do you believe stocks are safer the longer they are held

Post by graveday »

Wine usually gets better with age, but this is like asking if the longer you hold a rattlesnake the lesser the risk.
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Re: Do you believe stocks are safer the longer they are held

Post by bobcat2 »

Hi Brad,

I'm not sure I understand your question, but if your question is do really long dated options exist, I believe the answer is sort of. If you are a multi-millionaire (think Mitt Romney territory here), or a large enterprise, I believe an investment firm could tailor very long dated options for you for the right price. You wouldn't want to do this, however, for a piddling 10 million or less. :D Too costly.

I think market LEAPS options only go out a few years. Back in 2000 LEAPS went out 3 years, they may go out a somewhat further than that now.

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Re: Do you believe stocks are safer the longer they are held

Post by Bill M »

If you look at quotes in the options market, there is a clear pattern -- longer term options cost more. Both puts and calls. Financial professionals are the ones that determine those prices. I think the statement from financial professionals that stocks are safer when held longer is the height of hipocrisy.
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Re: Do you believe stocks are safer the longer they are held

Post by nisiprius »

Peter Foley wrote:Bobcat2
I agree that there are 30 year time periods where stock do not do as well. This does not, however, refute the Trinity Study which shows that in the past (not the future mind you) a portfolio containing more stocks than bonds has a higher probability of success over 30 year periods based on a 4% withdrawal rate. The portfolio with the lowest probability for success was a 100% bond portfoliog. :(
To "prove" that any riskier investment is "better," just pick a higher withdrawal rate. At some point 100% lottery tickets becomes the optimum. The question isn't which has the lowest failure rate if the failure rate is too high. Pick failure rate first, THEN ask for withdrawal rates as a function of asset alocation. Unless you,re very risk tolerant youll get à) lessnthan 4% and b) almost no effect from stock/bond allocation.
Last edited by nisiprius on Tue May 07, 2013 9:45 am, edited 1 time in total.
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Post by lazyday »

It might depend on assumptions and investing style.

If we assume that the investor is a person or institution, and will not be killed or destroyed by war or other adverse event, nor have assets confiscated (though they might become worthless), that can help improve long term vs short term odds.

Investing in just one or two asset classes in one country might lead to the same conclusion found by the academics. It might help to use more asset classes, including various global equities. I don’t know if any of the studies included several assets.

More importantly IMO, it might help to avoid assets priced for poor returns. A strategy might be used to always or often estimate expected returns. Any assets with poor expected returns are sold, such as Japan’s equity by the late 1980s, US largecap equity by the late 1990’s, and US long Treasuries by today. The assets would be redistributed into other assets with acceptable expected returns, and if none, into cash. (I suppose that’s cheating, so we might have to come up with a strategy that chooses the one or few least poor expected return assets when none are acceptable.)

I’m not suggesting that this is a great strategy to follow, or that it would work to make long term risk lower than short term, but I think that something like it might.

Ordinarily, something like this is done with some art, with personal judgement. I believe that it might be possible to create unthinking rules to do it methodically and reduce the risk of dangerous excursions into market timing or worse, performance chasing. But don’t know how.
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Re: Do you believe stocks are safer the longer they are held

Post by tadamsmar »

I think the basic Kelly criterion provides a good model for this:

http://en.wikipedia.org/wiki/Kelly_criterion

It just covers up or down bets, but Edward Thorpe extended it stock market applications. Samuelson has argued against use of the Kelly criterion, and Samuelson is a proponent the idea that stocks are not safer when held longer.

If you maximize expected growth using the Kelly criteria, then your risk of a N% decline at any time remains constant, it does not decline the longer you leave your money at risk. Therefore, you absolute risk (expressed in dollars not percent) grows. This is also true not just for maximized growth, it's true for any given growth rate expressed as a percent of working capital - it's true if you leave a constant percentage of working capital at risk.

But, if you are trying the fund a future project like retirement, the likelihood you can fund it grows with exposure to some risk, assuming the project is not too big relative to working capital. This assumes you cut back on (or eliminate) the risk when you start funding the project.
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Re: Do you believe stocks are safer the longer they are held

Post by tadamsmar »

tadamsmar wrote:I think the basic Kelly criterion provides a good model for this:

http://en.wikipedia.org/wiki/Kelly_criterion

It just covers up or down bets, but Edward Thorpe extended it stock market applications. Samuelson has argued against use of the Kelly criterion, and Samuelson is a proponent the idea that stocks are not safer when held longer.

If you maximize expected growth using the Kelly criteria, then your risk of a N% decline at any time remains constant, it does not decline the longer you leave your money at risk. Therefore, you absolute risk (expressed in dollars not percent) grows. This is also true not just for maximized growth, it's true for any given growth rate expressed as a percent of working capital - it's true if you leave a constant percentage of working capital at risk.

But, if you are trying the fund a future project like retirement, the likelihood you can fund it grows with exposure to some risk, assuming the project is not too big relative to working capital. This assumes you cut back on (or eliminate) the risk when you start funding the project.
Here's an example. Suppose you have the opportunity to invest repeatedly forever in an extremely favorable up or down bet. The bet pays 100 to 1, and your risk of losing the bet is only 1 chance in 1 million. You don't have to bet all your money, you can choose a fixed percentage of your working capital you want to bet.

Would repeatedly betting a modest fraction of your working capital on this bet be a good way to fund your retirement. Of course it would be!

Is is safer the longer you do it? No, your risk stays the same for any percentage loss. This extremely favorable bet has exactly the same characteristics that Samuelson, Brodie, Merton, et al, are railing against!

:moneybag

I rarely get the opportunity to slam dunk two Nobel prize winners at once! (Of course, it's not a real Nobel prize.)

PS: But Samuelson is probably arguing against full Kelly where you risk the fraction of you capital that maximizes growth. I am just showing that his objection obviously does not apply to all fractional Kelly bets. At least, the example shows that a investment policy can be a good one even if it does not get safer in the long run for a commonly use definition of "safer".
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Re: Do you believe stocks are safer the longer they are held

Post by tadamsmar »

The OP say Merton has warned people about stock long run risk.

Ironic that Merton founded LTCM, the hedge fund that went bust. In the book Fortune's Formula, Edward Thorpe points out that LTCM was engaging in reckless betting by betting more that the Kelly fraction of working capital that is the very mathematical definition of the threshold of recklessness.

Thorpe seemed to be engaging in schadenfreude over the comeuppance of his old foe in the debate over investment policy risks.
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Re: Do you believe stocks are safer the longer they are held

Post by baw703916 »

In terms of the variance of annualized returns, of course they become safer with longer holding times! I don't expect the annualized return of TSM over a 25 year period to ever be +35% or -35%, but it has exceeded both numbers for a one-year period.
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Re: Do you believe stocks are safer the longer they are held

Post by Splais »

Can a beginner comment?

To me the risk is constant and unknown at any specific time. How you reduce the risk is by extending the time you have stocks (invest early) and reducing your exposure to stocks the closer you get to needing the money. The market goes up and the market goes down. We can't know when, but we do know it does. We also can see that the market "usually" recovers it downs anywhere from 2-5 years. It also can have flat spots that last for as much as ten years. So depending on our willingness to gamble, we move out of stocks sometime between two and ten years from the time we anticipate needing the money.

I would seriously like to know if I'm starting to get it?
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Re: Do you believe stocks are safer the longer they are held

Post by rkhusky »

I am flipping a coin and have gotten 10 heads in a row. What are the odds that I will get another heads?
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Re: Do you believe stocks are safer the longer they are held

Post by bobcat2 »

Splais wrote:Can a beginner comment?

To me the risk is constant and unknown at any specific time. How you reduce the risk is by extending the time you have stocks (invest early) and reducing your exposure to stocks the closer you get to needing the money. The market goes up and the market goes down. We can't know when, but we do know it does. We also can see that the market "usually" recovers it downs anywhere from 2-5 years. It also can have flat spots that last for as much as ten years. So depending on our willingness to gamble, we move out of stocks sometime between two and ten years from the time we anticipate needing the money.

I would seriously like to know if I'm starting to get it?
No.

The risk is not constant. There are times when the risk in the stock market is much higher than average. These periods are known as volatility clusters.

For the most recent 13 year stock market period (2000-2013) the real return on the US stock was negative. The return on the Japanese stock market has been very negative over the last 23 years. The Japanese stock market today is worth less than 50% of what it was worth in 1989 in real terms.

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Re: Do you believe stocks are safer the longer they are held

Post by Verde »

I see Bodie's argument was mentioned (that higher option prices with longer time horizons proves that risk increases with time). So I am reposting a post of mine from years ago, maybe someone can answer my question.
alec wrote:IIRC, Bodie concluded that the cost of insuring against earning less than the risk-free rate of interest increases as the length of the investment horizon increases. Here's the paper.
No, Bodie observed that the cost of insuring against earning less than the risk-free rate of interest increases as the length of the investment horizon increases. I agree with his observation. He concluded based on his observation that risk increases with time. I disagree with his conclusion.
Figure 1. In his paper shows how the cumulative cost of insurance increases with time. I think he should have included the incremental cost of that insurance on that graph. It looks like this:
Image
As you can see the blue line (which Bodie showed us) reflects increasing cost as time passes.
The red line (which I calculated) shows how the cost to insure an additional year declines. Year 1 costs $7.97, year 2 $3.28, year 20 $0.82, year 100 $0.24 etc.

This has nothing to do with the time value of money. Bodie assumes a risk-free rate of 0%, so these are real values comparable across time.

I think this is in line with Samuelson. If I wanted to insure a stock portfolio, I would require a higher total premium the longer the term to compensate me for the greater magnitude of loss I might incur. I would however give a discount for each additional year because the probability that I would have to pay up decreases with time.

If Bodie used his argument to conclude that risk remains constant over time I would agree, but nothing in his paper convinces me that risk increases with time.
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Re: Do you believe stocks are safer the longer they are held

Post by baw703916 »

rkhusky wrote:I am flipping a coin and have gotten 10 heads in a row. What are the odds that I will get another heads?
I think the odds that it's not a fair coin are starting to go up. If you get 20 heads in a row it's pretty much a certainty.
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Re: Do you believe stocks are safer the longer they are held

Post by YDNAL »

rmelvey wrote:I see tons of posts saying that "I have a long time horizon so I can take a lot of risk" on this forum. So there appears to be a disagreement, or at the very least a misunderstanding of the theory of risk and return.

Personally, the idea of risk diminishing with time makes little sense to me.
I believe that you are mixing 2 things.
  • 1. The young has sufficient time to ride volatility in Stocks. (maybe true)
    2. Stocks are "less risky with time." (untrue)
See, the uncertainties in expected return, for risk taken, is what makes Stocks risky. If you don't believe me, talk to any alien from out of space that landed in Japan in 1989 and invested all alien-savings in the NIKKEI. :P
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Re: Do you believe stocks are safer the longer they are held

Post by Verde »

bobcat2 wrote: Yes our estimate of the future mean return may be in error. That was the point I was making. If we knew the "true" future mean return of equities then investing in equities would involve roughly the same amount of risk regardless of the holding period, because we would be closing in on the mean return over time, but the cumulative dispersion of returns would be increasing. But we don't know that, so investing in stocks becomes somewhat riskier the longer the holding period. Many people appear to assume that their expected return for stocks is the "true" mean return going forward. It is not, it is an estimate, and the fact that it is an estimate means they are underestimating the amount of risk entailed in investing in equities over the long-run.

BobK
I assume we all agree that the future mean return we would like to know, to eliminate this risk is the future real mean return.
In that case, does this estimation risk not exist for bonds as well.
'Stocks becomes somewhat riskier the longer the holding period' - relative to what?
Do you believe bonds are safer the longer they are held?
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Re: Do you believe stocks are safer the longer they are held

Post by nisiprius »

baw703916 wrote:In terms of the variance of annualized returns, of course they become safer with longer holding times! I don't expect the annualized return of TSM over a 25 year period to ever be +35% or -35%, but it has exceeded both numbers for a one-year period.
But variance of annualized returns is either at best irrelevant or at worst misleading. You have to compound them for the 25 years to get the relevant number, just like expenses, or probability of dodging black swans, or anything else. The apparent narrowing of the uncertainty is just the artificial result of taking the 25th root. Compound for 25 years and the seemingly small differences explode right back out again.
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Re: Do you believe stocks are safer the longer they are held

Post by plannerman »

Certainly TIPs held to maturity, even long TIPS, are safe in terms of known real return, Whether or not you can meet your financial goals investing in TIPS is another question.

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Re: Do you believe stocks are safer the longer they are held

Post by bobcat2 »

Do you believe bonds are safer the longer they are held?
I believe that what is determined by the length of the holding period is the safest asset.

In the theory of portfolio selection the risk-free (safest) asset is defined as the security that offers a perfectly predictable rate of return in terms of the selected unit of account and the length of the investor's decision horizon. That probably sounds confusing, but the following examples should clear things up.

Examples -
* If the unit of account is the US dollar and the decision horizon is three months, the safest asset is a Treasury bill that matures in three months.

* If the decision horizon is 20 years then the safest asset is a 20 year zero coupon Treasury bond, assuming the unit of account is nominal dollars.

* If the decision horizon is 15 years and the unit of account is real consumption, then the safest asset is a 15 year TIPS bond. If the decision horizon is every year until I die, and I am 62 or older and the unit of account is real consumption, then the safest asset is Social Security or an inflation-indexed life annuity.

* If the unit of account is college tuition and the decision horizon is 4 years of college beginning 6 years from now, then the safest asset is a pre-paid college tuition plan.

* If the unit of account is the Swiss franc and the decision horizon is nine months, then the safest asset is a franc bill that matures in nine months.

There is plenty of risk in cash (or ST Treasury bills) if the decision horizon is long. If the unit of account is real consumption and the decision horizon is long, cash becomes a very risky asset. Conversely if the decision horizon is short, a long dated TIPS bond is a very risky asset.

So for an asset to be safe it must have a known maturity date. Since stocks have no maturity date they are always risky assets and they do not get safer because the holding period is long.

BobK
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