Reality Check: Just How Risky Are Stocks?

Think stocks aren't for the risk averse?

That depends on your time frame, say the authors of a Morningstar studythat claims to be one of the most comprehensive into global long-term stock performance. Historically, when looking at inflation-adjusted returns, stocks have in fact been the safest asset class for investors, the study finds.

"This is just a further confirmation that when the holding period is longer, a risk-averse person can justify having a higher stock allocation," says Wade Pfau, a professor with the American College and one of the study's three coauthors. His collaborators are Michael Finke, a professor at Texas Tech, and David Blanchett, Morningstar's head of retirement research.

"This may seem like common sense to many financial planners," Blanchett says via email, but "this idea is actually counter to academic theory and things like options pricing models.

For example, he says, longer-duration call options are more expensive because of the time premium.


The authors say the study demonstrates the validity of "time diversification" -- the idea that stocks will become less risky over time -- and note that "these findings have important practical implications for individual and institutional investors with long investment periods, such as investors in target-date mutual funds and pension funds."

The authors looked at a huge data set, covering 20 countries going back to 1900. Many U.S. studies have looked only at the 90 years of data for the U.S., the authors argue, adding that none have offered both the global reach and the long time horizon.

To measure outcomes, the researchers constructed various optimal portfolios for those different countries based on varying levels of investor risk aversion and assuming a time horizon of 20 years, Blanchett says.

The study's conclusion: "While conventional economic theory suggests that time diversification should not exist with certainty, our analysis ... adds weight [to existing evidence] that time diversification does exist, or at least has existed historically."

Among the findings is that within a 30-year horizon, the annualized standard deviation of stocks is lower than annually reinvested Treasury bills. "This leads to the counterintuitive conclusion that risk-averse investors should demand stocks as a hedging strategy against a long-term drop in real consumption," the authors write.

The key for advisors, of course, is to understand exactly how the safer, longer time horizon maps against clients' own cash flow needs and affects portfolio construction techniques.

And the authors themselves offer a few caveats. Blanchett cautions that advisors shouldn't extrapolate tactical strategies from this study: "This is more about strategic asset allocation than making tactical decisions," he says.

And Pfau also cautions that while stocks have outperformed cash and/or bonds over the longer period, there is significant variation across countries regarding the level and the consistency of this outperformance.

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Comments (1)
Very valuable research and reporting! Thanks to Pfau, Finke, and Blanchett!

Their work reinforces evidence from the U.S. stocks asset class over the last century showing that over longer terms, dispersion of results becomes much less than shown by the random walk standardly assumed in Monte Carlo simulation.

Some sort of reversion toward some mean is at work, but there is no surefooted way to model that, because there are many ways to do so and woefully inadequate evidence to choose among them.

We've developed a way to explore effects of this reversion on prospects for clients' long-term dollar goals without making assumptions about how the reversion works. It's included in our newest version of Portfolio Pathfinder.

As the Pfau-Finke-Blanchett research confirms, this effect sure is worth exploring. From U.S. stocks history it appears to reduce uncertainty of 30-year results to only half that shown by traditional Monte Carlo!

Dick Purcell

Posted by Dick P | Tuesday, February 18 2014 at 3:50PM ET
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