June 28, 2011
Jeremy Siegel’s dictum – to invest in stocks for the long run – faces a new challenge. A recent paper by Robert Stambaugh, a Wharton colleague, and Lubos Pastor of the University of Chicago says that once you take into account the uncertainty of estimating future returns, stocks are not nearly as attractive to retirement-oriented investors as Siegel has claimed.
I’ll look at Pastor and Stambaugh’s research, but first I’ll review the rationale behind Siegel’s reasoning and explain why this is important to investors with long-time horizons.
American investors have an equity-oriented retirement model and increasingly fund their retirements through defined contribution plans. The conventional wisdom is that equities should play a major role in the asset allocation. Siegel is perhaps the best-known advocate for an equity-centric approach to asset allocation for retirement savings.
If we assume that stocks will return 8% per year with a 15% annualized volatility, for example, we can immediately see the virtues of Siegel’s argument. As one’s holding period increases, the probability that stocks will underperform bonds or risk-free assets diminishes.
But many investors are questioning whether they have the risk tolerance to hold substantial allocations in stocks given the volatility in equity markets in recent years, despite the long-term evidence that equities justify their volatility. Siegel steadfastly stands by his argument in favor of stocks.
Pastor and Stambaugh’s recent study presented a challenge to the case for equities. They approached this issue from a new angle in a 2009 paper titled Are Stocks Really Less Volatile In The Long Run? This paper is now listed as forthcoming in the Journal of Finance on Pastor’s website.
Pastor and Stambaugh argue that Siegel falsely assumes that investors can be highly confident that equities will outperform in the future because they have in the past. The problem is that investors never know with a high degree of certainty what the average return will be for stocks or other risky asset classes, nor can investors be very certain what future volatility will be. In other words, there is substantial estimation risk in addition to market risk. As Pastor said in a 2009 interview:
We are not interested in the backward-looking historical volatility but in the volatility that matters to forward-looking investors. Historical volatility is somewhat relevant to investors, but it does not fully capture all the uncertainties that investors face. Investors care not only about historical estimates but also about the uncertainty associated with those estimates. That uncertainty, which is sometimes called “estimation risk,” is included in the forward-looking measures of volatility that we compute. We find that estimation risk rises rapidly with the investment horizon, pushing up long-run volatility.
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