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Thursday, April 2, 2009

Stocks for the Long Run... Why Does Intra-Year Volatility Matter?

The NY Times had an article Now the Long Run Looks Riskier Too over weekend that makes the case that equity returns tend to be more volatile in the long-run than in the short run. I personally am having a hard time understanding why any of the points listed matter (bold mine):

Applying Bayesian techniques, the professors found that reversion to the mean isn’t powerful enough to overcome the growing uncertainty caused by other factors as the holding period grows. Specifically, they estimated that the volatility of stock market returns at the 30-year horizon is nearly one and a half times the volatility at the one-year horizon.

Why don’t traditional measures of volatility, such as standard deviation, pick up this phenomenon? Those measures focus only on how much the stock market’s shorter-term returns fluctuate around the long-term average, Professor Stambaugh says.
Looking at the annualized standard deviation of monthly returns over 5 and 30 year periods, we see that the shorter (i.e. 5 year periods) did tend to have lower volatility than 30 year periods, so yes it appears the statement is true.

The reason stated in the article is that there are things in this world that will have profound effects in the long-run, but not the short-run, thus causing longer term volatility:

One example of such a force, Professor Stambaugh said, is global warming. Its impact on the economy over the next 12 months is likely to be quite small, he said. But expand the horizon to the next several decades, and the possible effects of global warming range from negligible to catastrophic.
In my opinion this completely misses the mark. My thoughts? Well, business cycles tend to last anywhere between 3-6 years or so, thus market movements would tend to include the trend of the current business cycle in the short-run (i.e. one direction, thus a lower standard deviation), but if you extrapolate standard deviation over 30 years, you may have returns encompassing 6+ business cycles (i.e. whipsawing, thus greater volatility).

You say tomato, I say tomato (that doesn't quite work when written)... what matters more is where we end up, not how we got there. And while the article states that the past shouldn't be relied on (I agree), it is still useful to see how equities have performed. In looking at the past 100 years of 30-year rolling S&P 500 real returns (thus 130 years of data) we see the following:

Strong returns, typically yes. Reliable? To me, remarkably so. Over the past 100 years there really were no 30-year periods in which equities didn't at least keep up with inflation. Thus, my confusion as to the relevance of the following paragraph:

What is the investment implication of the new study? Other things being equal, Professor Stambaugh says, you would probably lower your portfolio allocation to stocks. But by how much? It’s impossible to generalize, since the answer depends on your time horizon and what else is in your portfolio.

If I am investing in equities and have 30 years until retirement, why does the intra-year volatility matter at all? What matters is unfortunately the timing of when I retire as compared to the last downturn (i.e. most investors continually invest, thus are more heavily weighted to movements at or near retirement). And unfortunately for those retiring in the near term, that is now.