Humble Dollar article: Investments..Time Can Take a Toll

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bondsr4me
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Humble Dollar article: Investments..Time Can Take a Toll

Post by bondsr4me »

I came across this article and thought to share it...curious about what you think.

https://humbledollar.com/2021/10/time-can-take-a-toll/

I hope the link works.
dbr
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by dbr »

The math of how variability compounds is important. A long time go-to article has been this one by John Norstad:

https://danluu.com/norstad/risk-time/#: ... frequently.

The usual departures from the simple example involve not assuming normal distributions and not assuming independence of sequential samples.

Some things that happen are that risk (variability) increases with time but the risk of meeting or failing to meet a fixed objective might increase with time or decrease with time.
secondopinion
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by secondopinion »

bondsr4me wrote: Tue Oct 12, 2021 1:43 pm I came across this article and thought to share it...curious about what you think.

https://humbledollar.com/2021/10/time-can-take-a-toll/

I hope the link works.
The biggest weakness of the article's argument is the assumption that the distribution would stay the same. Since quality in the economy is not completely removed from the stock market, sustained losses imply worsening quality. Not only does volatility increase with worsening quality, it starts to skew the returns from the usual negative skew to positive skew as poor gains (or even loss) will be more likely to happen (but the skew gives hope for massive returns should things improve). This is why bear markets are usually infrequent but are nevertheless aggressive.

Without factoring for this, people are left with the assumption that the stock market is the same market regardless of what happens; it is not. They wonder why they see long tails in the distribution, they underestimate downside risk, and they underestimate the amount gained in a recovery.
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nisiprius
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by nisiprius »

1) The general idea is confirmed by a more sophisticated analysis by Pastor and Stambaugh. I think this paper is the elephant in the living room. My feeling is that it's rarely mentioned because so many have been saying so long, and wish so badly, that stocks would be safer over longer holding periods.

Are Stocks Really Less Volatile in the Long Run?
Abstract

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.
2) People who claim stocks become safe over long holding periods often misrepresent and misquote Jeremy Siegel's work, which forms the core of his book Stocks for the Long Run. Siegel himself has explicitly disavowed the idea that stocks become less volatile with longer holding periods. My boldfacing:

Source
Now, one thing I should make very clear, I never said that that means stocks are safer in the long run. [This chart] is the standard deviation of average annual returns. We know the standard deviation of the average goes down when you have more periods. Even if it’s random walk, it goes down. What I pointed out here is that the standard deviation for stocks goes down twice as much— twice as fast as random walk theory would predict. In other words, they are relatively safer in the long run than random walk theory would predict. Doesn’t mean they’re safe.
3) Risk tolerance is fine. Risk denial is perilous. Stocks are risky over all holding periods. Risk tolerance means acknowledging that the risk really is there, and that you don't escape it just by being a long-term investor.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
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bondsr4me
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by bondsr4me »

nisiprius wrote: Wed Oct 13, 2021 6:48 am

3) Risk tolerance is fine. Risk denial is perilous. Stocks are risky over all holding periods. Risk tolerance means acknowledging that the risk really is there, and that you don't escape it just by being a long-term investor.
^^
Totally, totally agree with the above.
dbr
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by dbr »

nisiprius wrote: Wed Oct 13, 2021 6:48 am 1) The general idea is confirmed by a more sophisticated analysis by Pastor and Stambaugh. I think this paper is the elephant in the living room. My feeling is that it's rarely mentioned because so many have been saying so long, and wish so badly, that stocks would be safer over longer holding periods.

Are Stocks Really Less Volatile in the Long Run?
Abstract

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.
Surely no one ever thought that mean reversion would overcome the compounding of volatility and result in stocks becoming actually less risky in the long run. It sure doesn't take any more than an examination of history to support Pastor and Stambaugh.
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by firebirdparts »

It's a pretty esoteric argument, I guess. The idea of "less risky" gets tangled up in the idea of "average returns". There's a range. As you go farther out, the lower end of the range *in theory* goes lower. The lower end of the range *in USA practice* becomes higher. You have to decide which you believe in. In the end, the sun burned out.
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by nisiprius »

Image
dbr wrote: Wed Oct 13, 2021 10:15 am...Surely no one ever thought that mean reversion would overcome the compounding of volatility and result in stocks becoming actually less risky in the long run...
I see variations on this chart all the time. I am not sure where it originally came from--I suspect Ibbotson Associates but have never pinned it down. This particular chart is from the 2020 edition of Burton Malkiel's A Random Walk Down Wall Street and particularly poisonous because it is not inflation-corrected.

I first saw a chart like this in some TIAA-CREF literature circa 1990, and I misinterpreted it and thought exactly the thing that dbr says "surely no one ever thought."

Here's Malkiel's description:
note how the picture changes if you hold on to your common-stock investments for twenty-five years. Although there is some variability in the return achieved, depending on the exact twenty-five-year period in question, that variability is not large. On average, investments over all twenty-five-year periods covered by this figure have produced a rate of return of slightly more than 10 percent. This long-run expected rate of return was reduced by only about 4 percentage points if you happened to invest during the worst twenty-five-year period since 1950. It is this fundamental truth that makes a life-cycle view of investing so important. The longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio. In general, you are reasonably sure of earning the generous rates of return available from common stocks only if you can hold them for relatively long periods of time.
Is there careful weasel-wording here? I think it is easy to read

"...you are reasonably sure of earning the generous rates of return available from common stocks only if you can hold them for relatively long periods of time,"

and mistakenly think you have read

"you are reasonably sure of earning the generous rates of return available from common stocks if you can hold them for relatively long periods of time."
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
lws
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by lws »

bondsr4me wrote: Tue Oct 12, 2021 1:43 pm I came across this article and thought to share it...curious about what you think.

https://humbledollar.com/2021/10/time-can-take-a-toll/

I hope the link works.
Is this analysis based on the S&P500?
Northern Flicker
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by Northern Flicker »

bondsr4me wrote: Tue Oct 12, 2021 1:43 pm I came across this article and thought to share it...curious about what you think.

https://humbledollar.com/2021/10/time-can-take-a-toll/

I hope the link works.
The math in that article is incorrect. The author implicitly is making the incorrect assumption that returns aggregated into 1-year intervals are independent of each other. This likely will overestimate by a significant margin the variance of long-term returns, which is what the author is trying to quantify.
My postings are my opinion, and never should be construed as a recommendation to buy, sell, or hold any particular investment.
SmallSaver
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Re: Humble Dollar article: Investments..Time Can Take a Toll

Post by SmallSaver »

nisiprius wrote: Wed Oct 13, 2021 2:18 pm Image

[snipped]

Here's Malkiel's description:
note how the picture changes if you hold on to your common-stock investments for twenty-five years. Although there is some variability in the return achieved, depending on the exact twenty-five-year period in question, that variability is not large. On average, investments over all twenty-five-year periods covered by this figure have produced a rate of return of slightly more than 10 percent. This long-run expected rate of return was reduced by only about 4 percentage points if you happened to invest during the worst twenty-five-year period since 1950. (emphasis added - SmallSaver) It is this fundamental truth that makes a life-cycle view of investing so important. The longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio. In general, you are reasonably sure of earning the generous rates of return available from common stocks only if you can hold them for relatively long periods of time.
Is there careful weasel-wording here? I think it is easy to read

"...you are reasonably sure of earning the generous rates of return available from common stocks only if you can hold them for relatively long periods of time,"

and mistakenly think you have read

"you are reasonably sure of earning the generous rates of return available from common stocks if you can hold them for relatively long periods of time."
If I'm reading that chart right, it's also showing average annual return? The difference between 5.9% and 10% is massive over 25 years. "Only about 4 percentage points lower" winds up with a with a future value more than 60% lower.
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