Time diversification fallacy

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
Robert T
Posts: 2574
Joined: Tue Feb 27, 2007 9:40 pm
Location: 1, 0.2, 0.4, 0.5
Contact:

Time diversification fallacy

Post by Robert T » Fri Feb 29, 2008 9:13 pm

.
Shortfall risk goes down over long time horizons. If there’s an equity risk premium then the probably of a shortfall relative to the risk-free rate declines over time. This shortfall risk definition (or odds of success) is what many Monte Carlo simulations seem to use.

…but loss severity risk goes up. Quantified as the cost of insuring against a shortfall or more explicitly the price of a put option that guarantees at least the amount you would have got if you had invested in a treasury bond with a comparable maturity. For the S&P500 for example, the ‘insurance cost’ for a 25 year time horizon is about 6 times more expensive than the cost of a 1 year time horizon (as I understand). So loss severity risk goes up over time even though shortfall risk goes down. So time diversification does not reduce risk as much as is often assumed.

Implications?
- rely more on asset class diversification to reduce risk, not time.
- direct holdings of treasury inflation protected securities held to maturity as fixed income holdings, rather than bond mutual funds can reduce ‘loss severity risk’ by ensuring a ‘guaranteed’ real return for at least part of a portfolio.

Just my understanding - any other interpretations?

Robert
.
(Zvi Bodie highlights this point in “The Next Generation of Life-Cycle Investment Products “ for those interested here is the link to a webcast of this presentation http://www.cfawebcasts.org/cpe/what.cfm?test_id=698)
.

User avatar
craigr
Posts: 2696
Joined: Tue Mar 13, 2007 6:54 pm

Re: Time diversification fallacy

Post by craigr » Fri Feb 29, 2008 9:44 pm

Robert T wrote:Just my understanding - any other interpretations?
John Norstad discusses this point as well:

http://homepage.mac.com/j.norstad/finan ... ml#fallacy

I'm not as polished as Mr. Norstad. To me, the fallacy of time diversification can be summarized as this:

100% stock is like Russian Roulette, your risk of blowing your head off does not go down the longer you play the game.
Last edited by craigr on Sat Mar 01, 2008 4:31 pm, edited 1 time in total.

timid investor
Posts: 598
Joined: Thu Sep 27, 2007 9:05 pm
Location: alabama

Re: Time diversification fallacy

Post by timid investor » Sat Mar 01, 2008 11:56 am

Robert T wrote:.
Shortfall risk goes down over long time horizons. If there’s an equity risk premium then the probably of a shortfall relative to the risk-free rate declines over time. This shortfall risk definition (or odds of success) is what many Monte Carlo simulations seem to use.

…but loss severity risk goes up. Quantified as the cost of insuring against a shortfall or more explicitly the price of a put option that guarantees at least the amount you would have got if you had invested in a treasury bond with a comparable maturity. For the S&P500 for example, the ‘insurance cost’ for a 25 year time horizon is about 6 times more expensive than the cost of a 1 year time horizon (as I understand). So loss severity risk goes up over time even though shortfall risk goes down. So time diversification does not reduce risk as much as is often assumed.

Implications?
- rely more on asset class diversification to reduce risk, not time.
- direct holdings of treasury inflation protected securities held to maturity as fixed income holdings, rather than bond mutual funds can reduce ‘loss severity risk’ by ensuring a ‘guaranteed’ real return for at least part of a portfolio.

Just my understanding - any other interpretations?

Robert
.
(Zvi Bodie highlights this point in “The Next Generation of Life-Cycle Investment Products “ for those interested here is the link to a webcast of this presentation http://www.cfawebcasts.org/cpe/what.cfm?test_id=698)
.

I can't help but laugh every time this drivel (Time diversification fallacy)gets serious consideration for implications as a primary driver of a real portfolio.

I mean shortfall risk trumps in a real world portfolio, otherwise the boglehead philosophy must embrace the shortest holding period possible overcoming the vig.

snowman9000
Posts: 1001
Joined: Tue Feb 26, 2008 10:16 am

Post by snowman9000 » Sat Mar 01, 2008 12:05 pm

What are the odds of a 90% loss in the US stock market when you need your money? What are the odds of a simultaneous meltdown in all US investment markets? Zero? I don't think so.

What are the odds of a house in the US being destroyed by a tornado? I dunno, maybe 50,000 or 100,000 to 1? My house was destroyed by a tornado! (Really.) I have insurance for tornadoes.

Most investors in the US markets have inadequate or no insurance against a catastrophic loss.

Trebor
Posts: 293
Joined: Wed Feb 21, 2007 1:36 pm

Post by Trebor » Sat Mar 01, 2008 12:12 pm

Thanks. I enjoyed the presentation.
Bodie seems to have a problem with the “need” to take risk. If you “need” to take risk to reach a goal, he would rather you save more or delay your goal instead. He believes in products with a “guarantee” built in. These guarantees come at a cost. The longer the time horizon, the greater the cost will be.

It seems to me, the cheapest guaranteed products are Tips. One could pursue a Bodie strategy by planning for a bare minimum future value goal using Tips. Left over money could be placed in higher risk products based on one’s willingness and ability to bare risk.

Again, I enjoyed the talk. I agree with the fallacy of time diversification. I am not sure about Bodie’s strategy and recommendations.

Trebor

SmallHi
Posts: 1718
Joined: Wed Feb 21, 2007 6:11 pm

Post by SmallHi » Sat Mar 01, 2008 1:03 pm

Just my understanding - any other interpretations?
Robert, an excellent post and interesting suggestions. I agree that broad asset class (risk based) diversification is an important conclusion.

I don't, however, necessarily agree that because we run the risk of long term shortfall through the exclusive reliance on risky equity dimensions that we should always add copius amounts of risk free assets or portfolio insurance (short term nominal bonds and TIPS). For one, I am not sure inflation +1% (approximate TIPS return in 10 years) is enough to save anyone from personal financial catastrophe.

I think, instead, we should prepare ourselves for future uncertainty by focusing more on our selves and our future productive capabilities. Embrace education, strive to always grow your knowledge set. Live a well balanced, meaninful life focused on health, well being, and family.

In my opinion, having the flexibility to alter your financial path in life is a better course of action than an overallocation to portfolio insurance.

Financial catastropy (however you define it) is but one possible future scenerio that deserves to be assigned a rightful probability. How one overcomes that potential can possibly vary greatly.

An overemphasis on financial catastrophe, unfortunately, can produce unacceptable long term results in future scenerios where the worst case hasn't shown up.

Just some random, knee-jerk thoughts.

sh

Warner
Posts: 184
Joined: Thu Apr 19, 2007 2:35 pm

Post by Warner » Sat Mar 01, 2008 1:53 pm

The Buttonwood column wrote about long-term stock risk a few months ago, referencing Dimson, Marsh & Stauton's Irrational Optimism:
We address the tendency of many investors to overestimate the rewards and underestimate the risks of investing in stocks over the long term - that is, investors' irrational optimism. In particular, we examine the widely held belief that stocks are a "safe" investment for the long run.

Three trends seem likely for the future. First, equity investment will continue to remain risky. Business itself is risky, and the years ahead may well bring new forms of disorder and volatility. The counterparts of international conflict and the Cold War may be new wars on terror, drugs, and the forces of nature. On the upside, business opportunities may arise that are barely reflected in today’s stock prices.

Second, given that equities will remain risky, investors should continue to expect a reward for risk. That is, when investors look back a century from now, equities should prove to have been the best performing asset class in the 21st century. Nevertheless, the real return on stocks will turn out to be lower than it was in the 20th century.

Third, stocks do not and cannot offer a guaranteed superior performance over the investment horizon of most investors. To maximize the probability of favorable real returns, equities should be held within a diversified portfolio. Equity exposures should be diversified globally, so as to dampen domestic stock market volatility. By including multiple asset classes, risk can be brought down still more. If investors fail to diversify efficiently and cost-effectively, they can expect to erode the reward for equity risk exposure.

Equities continue to have an important role in long-term portfolios. However, their prospective returns are lower than the performance that many investors project, while their risk is higher than many investors appreciate. Investors or corporations who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational.

User avatar
bobcat2
Posts: 5339
Joined: Tue Feb 20, 2007 3:27 pm
Location: just barely Outside the Beltway

To Infinity and Beyond

Post by bobcat2 » Sat Mar 01, 2008 2:27 pm

More from the Buttonwood column.
Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School examined the record of 16 stockmarkets which were in continuous operation over the course of the 20th century. In itself, this selection showed survivorship bias by excluding the likes of Russia and China. The academics found that only three other countries could match the American record of having no 20-year periods with negative real returns.

Other investors were far less lucky. Japanese, French, German and Spanish investors all suffered instances where they had to wait 50-60 years to earn a positive real return; in Italy and Belgium, the waiting period stretched to 70 years. It was no good following the famous advice to “put the shares in a drawer and forget about them”; the furniture would not have lasted that long.

Besides survivorship bias, there is another problem with the belief that stockmarkets must always go up; the very existence of the belief is likely to lead to its falsification. Investors will keep buying until prices reach stratospheric levels. That clearly happened in Japan in the late 1980s and with the technology-heavy NASDAQ index in the late 1990s; the latter is still, after seven years, not much more than half its peak level.

A significant proportion of the return from equities in the second half of the 20th century came from a re-rating of shares; investors were willing to pay a higher multiple for profits. But re-rating cannot continue forever. Although ratings have fallen significantly since the heady days of 2000, that is in large part due to the remarkable strength of corporate profits, now close to a 40-year high relative to national output. If profits revert to the mean, that could act as a drag on stockmarket performance. And, as with Japan, investors do not have much in the way of income to fall back on; the dividend yield on the American market is just 1.7%.

If investors want a simple parallel with share prices, they need only turn to the American housing market. Back in 2005, Ben Bernanke, then an economic adviser to the president, was asked about the possibility of a decline in house prices on CNBC, a financial-television channel. He said, “We've never had a decline in housing prices on a nationwide basis. What I think is more likely is that house prices will slow, maybe stabilise.”

Lots of people took the same view and were willing to borrow (and lend) on a vast scale on the grounds that higher house prices would always bail them out. They are now counting their losses. Investors in equities should beware of overcommitting themselves on the basis of a similar belief. Just ask the Japanese.
Bob K
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

User avatar
SpaceCommander
Posts: 517
Joined: Thu Nov 08, 2007 4:13 pm
Location: Seattle
Contact:

Re: Time diversification fallacy

Post by SpaceCommander » Sat Mar 01, 2008 2:37 pm

craigr wrote:100% stock is like Russian Roulette. Your risk of blowing your head off does not go down the longer you play the game.
Well said.
snowman9000 wrote:What are the odds of a house in the US being destroyed by a tornado? I dunno, maybe 50,000 or 100,000 to 1? My house was destroyed by a tornado! (Really.) I have insurance for tornadoes.

Most investors in the US markets have inadequate or no insurance against a catastrophic loss.
Absolutely agree. The key to success is avoiding large losses.

Good stuff. Thanks for this discussion.

JC
I honor my personality flaws, for without them I would have no personality at all.

MikeA01730
Posts: 46
Joined: Mon Sep 24, 2007 10:32 am

Re: Time diversification fallacy

Post by MikeA01730 » Sat Mar 01, 2008 2:42 pm

I understand and am in agreement with everything in the original post except this:
Robert T wrote:Implications?
- direct holdings of treasury inflation protected securities held to maturity as fixed income holdings, rather than bond mutual funds can reduce ‘loss severity risk’ by ensuring a ‘guaranteed’ real return for at least part of a portfolio.
What's the problem with TIPS held in in mutual funds? It seems to me that the advantages of funds pertain here in the same way they do with other securities, and there's no problem unique to TIPS. Can anyone explain this point?

Thanks,
Mike

peter71
Posts: 3768
Joined: Tue Jul 24, 2007 8:28 pm

Post by peter71 » Sat Mar 01, 2008 3:05 pm

my take is that while the historical evidence is clear that time reduces the SD of equities, that's a far cry from saying, "i'm willing to bet (via this options contract) that you'll definitely beat 6% annualized over 40 years . . . not for any of the mathematical reasons Norstad et al. talk about, but because of catastrophic events (though it's important to note that these catastrophic events may also affect bonds, and perhaps even real estate).

all best,
pete

User avatar
bobcat2
Posts: 5339
Joined: Tue Feb 20, 2007 3:27 pm
Location: just barely Outside the Beltway

TIP bonds vs TIP mutual funds

Post by bobcat2 » Sat Mar 01, 2008 3:37 pm

Mike,

If you hold a TIP 20 year bond you know exactly how much you will have in 20 years in real (inflation-adjusted) terms when the bond matures. Therefore, you can match a 20 year real liability with this 20 year real asset. This property does not hold for TIP mutual funds held for 20 years, because the fund has no fixed maturity.

Bob K
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

snowman9000
Posts: 1001
Joined: Tue Feb 26, 2008 10:16 am

Re: To Infinity and Beyond

Post by snowman9000 » Sat Mar 01, 2008 4:20 pm

bobcat2 wrote:More from the Buttonwood column.


Other investors were far less lucky. Japanese, French, German and Spanish investors all suffered instances where they had to wait 50-60 years to earn a positive real return; in Italy and Belgium, the waiting period stretched to 70 years. It was no good following the famous advice to “put the shares in a drawer and forget about them”; the furniture would not have lasted that long.
Bob K
Darn right. Americans take some things for granted, thinking they cannot happen here. (Softened my tirade via edit.)
Last edited by snowman9000 on Sat Mar 01, 2008 5:15 pm, edited 1 time in total.

MikeA01730
Posts: 46
Joined: Mon Sep 24, 2007 10:32 am

Post by MikeA01730 » Sat Mar 01, 2008 4:34 pm

Bob K,

I agree that if you know you have a specific time horizon, buying a bond that matches that horizon makes the most sense.

I have no specific time horizon in mind: I want to protect my assets from inflation continually for the rest of my life. For that purpose I think a fund makes more sense.

In any case your point pertains to any bond holding, not just TIPS, right?

Mike

Valuethinker
Posts: 38218
Joined: Fri May 11, 2007 11:07 am

Re: To Infinity and Beyond

Post by Valuethinker » Sat Mar 01, 2008 4:44 pm

snowman9000 wrote:
bobcat2 wrote:More from the Buttonwood column.


Other investors were far less lucky. Japanese, French, German and Spanish investors all suffered instances where they had to wait 50-60 years to earn a positive real return; in Italy and Belgium, the waiting period stretched to 70 years. It was no good following the famous advice to “put the shares in a drawer and forget about them”; the furniture would not have lasted that long.
Bob K
Darn right. Americans are IMO not critical students of non-US history. We believe that bad things that happened in other civilized countries could not possibly happen here. We are just too smart, too enlightened, and too good to have a political or economic nightmare.

Whatever.
One is reminded of various ructions in American history: the Civil War and the aftermath, down to the Civil Rights period.

Or the events around Watergate (at the same time as serious stagflation).

Some of the booms and busts of the 19th century, and the prolonged slump at the end of the 19th century.

Or the Great Depression, and the political earthquake that swept through as a result. An earthquake that might have brought Huey Long to power, surely the closest thing to a successful fascist politician the US ever created (historians think Long's strategy was to ensure FDR's defeat in 1936, and then run as the nominee in 1940 defeating an unpopular Republican. Given the lack of success FDR experienced in his second term, and the likely lack of success a Republican president would have achieved eg against the slump of 1938, that is not impossible).

None of these were/ would have been great for stock markets.

I am something of an optimist re the USA: being an outsider, your problems seem less serious than you perhaps imagine, and the resourcefulness of your people to solve them greater.

Nonetheless events over the last 110 years or so have been extraordinarily kind to the US stock market, and it's unlikely the confluence of factors will be quite so favourable in the future.

User avatar
bobcat2
Posts: 5339
Joined: Tue Feb 20, 2007 3:27 pm
Location: just barely Outside the Beltway

Post by bobcat2 » Sat Mar 01, 2008 6:11 pm

Mike wrote:
In any case your point pertains to any bond holding, not just TIPS, right?
No - With TIPS you know what you will have in real (inflation-adjusted) terms. With nominal bonds you will have a nominal amount, which could easily be quite disappointing in real terms. :(

If you laddered your TIP bonds you would know exactly how much in the future you could spend per year in real terms, e.g. a ladder of TIPS worth $20,000 real per year during retirement.

Bob K
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

biasion
Posts: 1417
Joined: Mon Aug 13, 2007 8:23 pm

Post by biasion » Sat Mar 01, 2008 9:53 pm

[removed]
1. Do not confuse strategy with outcome | 2. Those who fail to plan plan to fail | 3. Do not assume the unlikely is impossible, and | 4. Be ready to deal with the consequences if you do.

User avatar
Random Musings
Posts: 5389
Joined: Thu Feb 22, 2007 4:24 pm
Location: Pennsylvania

Post by Random Musings » Sun Mar 02, 2008 12:21 am

Nonetheless events over the last 110 years or so have been extraordinarily kind to the US stock market, and it's unlikely the confluence of factors will be quite so favourable in the future.
It also didn't probably hurt that the U.S. enjoyed a post WW-II situation where our infrastructure and factories were all left standing while many of the other major economic powers of that time didn't.

RM

HerbertSitz
Posts: 684
Joined: Fri Feb 01, 2008 8:52 pm

Re: Time diversification fallacy

Post by HerbertSitz » Sun Mar 02, 2008 1:05 am

Robert T wrote: …but loss severity risk goes up. Quantified as the cost of insuring against a shortfall or more explicitly the price of a put option that guarantees at least the amount you would have got if you had invested in a treasury bond with a comparable maturity. For the S&P500 for example, the ‘insurance cost’ for a 25 year time horizon is about 6 times more expensive than the cost of a 1 year time horizon (as I understand). So loss severity risk goes up over time even though shortfall risk goes down. So time diversification does not reduce risk as much as is often assumed.
I'm curious about this use of S&P500 puts as way to hedge risk of 100% equity portfolio.

Does anyone know where Bodie's getting these numbers for option prices or have links to info on how they're calculated?

I'm no cfa, but won't the choice of American or European style option have an impact on extent to which option price grows as maturity is extended out? 25 year American option could be exercised any time during the 25 years if S&P500 dipped below risk-free return. So if it happened at year 10 an investor might choose to capture gain by exercising the put and then throw all the proceeds right back into 100% equity. And with European-style option investor would be restricted to exercise only at the 25 year anniversary date.

User avatar
gummy
Posts: 340
Joined: Mon Mar 12, 2007 2:34 pm
Location: Burlington, Ontari-ari-ari-O
Contact:

Post by gummy » Sun Mar 02, 2008 4:26 am

Time Diversification always confuses me :cry:

User avatar
Topic Author
Robert T
Posts: 2574
Joined: Tue Feb 27, 2007 9:40 pm
Location: 1, 0.2, 0.4, 0.5
Contact:

Post by Robert T » Sun Mar 02, 2008 5:45 am

.
Here’s an attempt at an example to illustrate what I was trying to say in the first post (I find it useful – hope others do).

The example uses a 70:30 US large cap:t-bill portfolio (the distribution of annual returns used are from pg.121 of Gibson’s latest version of Asset Allocation)

Assume that an investor has a target return of 8.3%, and a portfolio is designed with an expected return to meet this target. The estimated distribution of returns is reflected in the table below.

Two examples for reading the table: There’s a 75% likelihood that the actual return of the portfolio in year 25 will be higher than 6.45% (or put another way, a 25% likelihood that it will be less than 6.45%). Similarly, there’s a 75% likelihood that the portfolio value (from $1 invested) in 25 years will be above $4.77 (or put another way, a 25% likelihood that it will be less than $4.77).

The numbers shows that the spread of likely annualized returns declines over time, but the spread of likely ending portfolio values increases over time.

Code: Select all

Distribution of annual returns: Variance DECLINES over time

Year       1st%    10th%   25th%   50th%  75th%   90th%   99th%
1        -19.54   -8.06   -0.64    8.29   18.03   27.56   45.75
25         2.05    4.80    6.45    8.29   10.17   11.90   14.92

Distribution of growth in $1: Variances INCREASES with time

Year       1st%    10th%   25th%   50th%  75th%   90th%   99th%
1          0.80    0.92    0.99    1.08    1.18    1.28    1.46
25         1.66    3.23    4.77    7.32   11.26   16.62   32.35

* The first table is a direct extract from Gibson's book
Another interpretation is that in year 1, there’s a one in four chance that this portfolio’s value will be less than 92% of the target value (1.08/1.18*100). In year 25 there’s a one in four chance that it will be less than 65% of the target value (4.77/7.32*100) e.g. ending with 477k versus the target amount of 732k for 100k invested (a 255k difference). IMO that’s a big difference and the difference widens as a portfolio’s standard deviation increases. This suggests that paying attention to reducing a portfolio’s expected standard deviation is important in portfolio design if the objective is to improve the likelihood of reaching a future target portfolio value. Obviously its not possible to price perfection into the analysis and a subsequent plan – but this is nevertheless instructive (IMO).

Robert
.

User avatar
Topic Author
Robert T
Posts: 2574
Joined: Tue Feb 27, 2007 9:40 pm
Location: 1, 0.2, 0.4, 0.5
Contact:

Post by Robert T » Sun Mar 02, 2008 6:09 am

Smallhi,

I agree on the multitude of risks and think that a more comprehensive approach to addressing them is better than a less comprehensive approach. And also think a broader financial strategy is better than simply an investment strategy (the former including an approach to broader insurance – disability, life, health, estate plan etc., as well and investments in ourselves to enhance ‘our future productive capacities’). This approach considers more explicitly both human and financial capital.

On investment risk, I would not reduce savings to rely on a higher expected return (higher risk) portfolio to fund future consumption. Nor would I increase savings to relay on a lower expected return portfolio (lower risk portfolio) if there’s a huge cost to current consumption. Live for the present, plan for the future. As always – balance is key.

As indicated earlier – there is no way to price perfection into any plan – flexibility and adjustment will likely be needed along the way.

Robert
.

User avatar
nisiprius
Advisory Board
Posts: 38505
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Time diversification fallacy

Post by nisiprius » Sun Mar 02, 2008 7:36 am

timid investor wrote:I mean shortfall risk trumps in a real world portfolio, otherwise the boglehead philosophy must embrace the shortest holding period possible overcoming the vig.
There isn't any such thing as "shortfall risk" unless you are counting on the portfolio to meet some specific amount at a specific date and you cannot alter or control that amount, or the size of the contributions that are being made to reach it.

A pension manager might well worry about "shortfall risk." The pension fund's incoming funds aren't under his control, the outgoing obligation isn't under his control, the only thing under his control is the investment mix.

A "real world" investor who is an ordinary middle-class guy saving for retirement can control his own goals, his own timeframe for meeting them, and the portion of his income that he allocates toward meeting them.

The idea that "time diversification" guarantees a certain rate of return from stocks--or, more specifically, guarantees that socking away X% of your paycheck into an equity-heavy 401(k) will produce Y million dollars--is flawed.

Maybe this is not what the "retirement 101" workbooks actually say, but it is, very clearly, what many retirement savers believe.

People are being led down the garden path of fantasizing some number $Y million they "need" in retirement, treating it as cast in stone, then working back assuming that stock returns are guaranteed to conclude they only need to save X% of their paycheck.

The downside "risk" only exists as a result of picking a high value of Y and a low value of X. But both of these are completely under the investor's control.

I believe people are saving too little, expecting too much, and being led to take higher risks than they know they are taking, because of the truth of a narrow range of "average annual returns" is misinterpreted to mean "narrow range of total assets accumulated."
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.

ajbibi
Posts: 196
Joined: Mon May 07, 2007 10:27 pm

Post by ajbibi » Sun Mar 02, 2008 9:01 am

snowman9000 wrote: What are the odds of a house in the US being destroyed by a tornado? I dunno, maybe 50,000 or 100,000 to 1? My house was destroyed by a tornado! (Really.) I have insurance for tornadoes.

Most investors in the US markets have inadequate or no insurance against a catastrophic loss.
I use a similar example when discussion how inconsistent people are about insurance. Lots of people will play $50-$100 for an extended warranty on their washing machines but will not spend the couple hundred per year for earthquake insurance on their $500,000 home.

The former is very bad gamble with low downside. The latter is a rare event with enormously bad downside -- perfect for insurance.

I think that -- thanks to our socialized medical insurance structure -- people have been conditioned to believe that insurance is really a prepayment plan for lifetime expenses matched by government subsidies.

So few people understand what insurance is supposed to do that it's not a surprise that few build into a sensible planned portfolio.

Valuethinker
Posts: 38218
Joined: Fri May 11, 2007 11:07 am

Post by Valuethinker » Sun Mar 02, 2008 9:55 am

ajbibi wrote:
snowman9000 wrote: What are the odds of a house in the US being destroyed by a tornado? I dunno, maybe 50,000 or 100,000 to 1? My house was destroyed by a tornado! (Really.) I have insurance for tornadoes.

Most investors in the US markets have inadequate or no insurance against a catastrophic loss.
I use a similar example when discussion how inconsistent people are about insurance. Lots of people will play $50-$100 for an extended warranty on their washing machines but will not spend the couple hundred per year for earthquake insurance on their $500,000 home.

The former is very bad gamble with low downside. The latter is a rare event with enormously bad downside -- perfect for insurance.
I think that -- thanks to our socialized medical insurance structure -- people have been conditioned to believe that insurance is really a prepayment plan for lifetime expenses matched by government subsidies.
I am pretty sure that is a logical nonsequitur.

It doesn't follow from the fact that humans overestimate the pain and cost of small losses, and underestimate the cost of low probability high loss events that the US medical insurance system is wrong. In particular its not just Americans who are irrational about insurance this way.

Far more people have a fear of flying than a fear of driving, yet statistically driving is much more likely to kill you.

Turn it the other way, other countries have a different medical system than the US, but their citizens also have irrational views about insurance risk.

Another interesting one is Long Term Disability. Americans (and other countries) seriously underinsure against the risk to labour income of disability. Yet the loss, should you be disabled, and the probability of being disabled are much higher than we tend to estimate.

Maybe you could explain how you think these deeply held misbeliefs are encoded into the US medical insurance system?

Wagnerjb
Posts: 7203
Joined: Mon Feb 19, 2007 8:44 pm
Location: Houston, Texas

Post by Wagnerjb » Sun Mar 02, 2008 11:13 am

Nonetheless events over the last 110 years or so have been extraordinarily kind to the US stock market, and it's unlikely the confluence of factors will be quite so favourable in the future.
Why does time diversification have to be a narrow bet on one country? Investors should diversify their equity exposure globally. Let's not disparage the benefits of time diversification when the real problem is plain vanilla diversification.

Best wishes.
Andy

Valuethinker
Posts: 38218
Joined: Fri May 11, 2007 11:07 am

Post by Valuethinker » Sun Mar 02, 2008 1:49 pm

Wagnerjb wrote:
Nonetheless events over the last 110 years or so have been extraordinarily kind to the US stock market, and it's unlikely the confluence of factors will be quite so favourable in the future.
Why does time diversification have to be a narrow bet on one country? Investors should diversify their equity exposure globally. Let's not disparage the benefits of time diversification when the real problem is plain vanilla diversification.

Best wishes.
There has been increased correlation between US markets and other developed stock markets. And even EM ones.

The diversification benefit from international equity investing is falling.

Whether this will reverse at some point (say due to a reimposition of exchange controls or trade barriers) I don't know, but looking forward it is a consideration.

In the last 100 years, in any case, if you were a US investor, international diversification most likely *reduced* your returns. I think only 2-3 developed markets outperformed the US since 1900.

HerbertSitz
Posts: 684
Joined: Fri Feb 01, 2008 8:52 pm

Re: Time diversification fallacy

Post by HerbertSitz » Sun Mar 02, 2008 2:07 pm

nisiprius wrote:There isn't any such thing as "shortfall risk" unless you are counting on the portfolio to meet some specific amount at a specific date and you cannot alter or control that amount, or the size of the contributions that are being made to reach it.
I think the idea is that there is limited control over what amount a person will need as they enter retirement and how much they will be able to contribute.

Yes, if they're shooting to retire on $10M they have plenty of room to lower it. If, however, they're an average person who believes they need $1M in 2008 dollars (or even somewhat more), there's far less room to adjust down without greatly affecting standard of living.

And, yes, there is some ability to increase contributions to reach the goal. But given that few people have incomes as high as they'd wish, ability to increase contributions is limited.

So in that sense there certainly is shortfall risk. There's limited control over how much a person will need at future point of retirement and in their ability to invest amounts to meet that need.

Also, I think you're setting up a straw man when you argue that many believe you're somehow "guaranteed" a higher return with 100% equities over long period of time. At least if you take "guarantee" with its usual meaning of zero chance of being wrong. People argue that you have higher odds of reaching your target amount, not having a shortfall, if you have higher equity allocation. That is true, and acknowledged even by Zvi Bodie, although Bodie also argues that the severity of possible shortfalls also increases so shortfall risk is not primary thing to focus on.
Last edited by HerbertSitz on Mon Mar 03, 2008 4:33 pm, edited 1 time in total.

Wagnerjb
Posts: 7203
Joined: Mon Feb 19, 2007 8:44 pm
Location: Houston, Texas

Post by Wagnerjb » Sun Mar 02, 2008 7:58 pm

Valuethinker said:
There has been increased correlation between US markets and other developed stock markets. And even EM ones.

The diversification benefit from international equity investing is falling.

Whether this will reverse at some point (say due to a reimposition of exchange controls or trade barriers) I don't know, but looking forward it is a consideration.
Fine, but that doesn't invalidate the fact that international diversification is a sound strategy. And that it would have saved investors from the examples of ruin that have afflicted one particular country in our history.
In the last 100 years, in any case, if you were a US investor, international diversification most likely *reduced* your returns. I think only 2-3 developed markets outperformed the US since 1900.
I am not sure this is relevant. Even if we knew this to be true in advance, I am not sure I would avoid international stocks just because I paid a small price for the lower volatility and risk.

There is indeed risk in time diversification, but it looks a lot more like a major economic crisis that affects most of the world's economies together.

Best wishes.
Andy

timid investor
Posts: 598
Joined: Thu Sep 27, 2007 9:05 pm
Location: alabama

Re: Time diversification fallacy

Post by timid investor » Mon Mar 03, 2008 12:31 am

craigr wrote:
Robert T wrote:Just my understanding - any other interpretations?
John Norstad discusses this point as well:

http://homepage.mac.com/j.norstad/finan ... ml#fallacy

I'm not as polished as Mr. Norstad. To me, the fallacy of time diversification can be summarized as this:

100% stock is like Russian Roulette, your risk of blowing your head off does not go down the longer you play the game.
true but 100% bonds is like playing russian roulette with a semi-automatic
if you don't start out with enough capital.

User avatar
craigr
Posts: 2696
Joined: Tue Mar 13, 2007 6:54 pm

Re: Time diversification fallacy

Post by craigr » Mon Mar 03, 2008 1:11 am

timid investor wrote:true but 100% bonds is like playing russian roulette with a semi-automatic if you don't start out with enough capital.
I don't think 100% in anything is a good idea. Whether it's 100% stock, 100% bonds, 100% cash, 100% real estate or 100% TIPS risk can show up. Anything can happen in investing. I don't like to dismiss any possibility, even ones that seem unlikely.

However the "100% stock is safe if you have enough time" myth gets thrown around the most. Longer time horizons do not lower your risk with stock ownership. The longer you go out the much more uncertain returns become.

I don't think anything should be taken for granted in investing and this certainly includes the idea that stocks are always going to out-perform or recover value over a particular segment of time. A 100% stock portfolio may recover, but it may not be on an investor's particular timetable.

Post Reply