Stocks still risky in the long run

KONICA MINOLTA DIGITAL CAMERA Yesterday I talked about how the market is far, far from efficient.  Today, I want to point you in the direction of a Wharton interview with Robert Stambaugh and Jeremy Siegel, who discuss the idea of stock volatility in the long run.

In the long run, instead of falling volatility, we are in fact faced with more trend uncertainty that compounds the short-term volatility problem. Uncertainty about the trend itself becomes more important than the actual volatility itself.  More specifically:

That uncertainty about the trend itself becomes more important the further into the future you project investment outcomes. […] to an investor with a long horizon, stocks actually are riskier per period. That is, the rate at which risk grows over the horizon such that it makes the investment riskier over the long run.

The other feature of the stock market that contributes to uncertainty is the fact that at some points in time we think the expected rate of return is higher than at other points in time. In other words, over time the rate of return that you can expect to earn over the short- and intermediate-terms fluctuates. The fact that the expected return fluctuates also adds to uncertainty because we do not know — for example — if expected returns are currently high, which many of us would guess they are. We don’t really know how long they’re going to stay high.

Using global warming as an example of uncertainty a long term horizon is subjected to:

It provides an interesting analogy to this concept because we might be very uncertain about how quickly the Earth is warming, but that uncertainty doesn’t much impact our uncertainty about crop output and economic output next year.  But if we look 50 years down the road, uncertainty about the rate [at which the Earth is warming] has a much bigger impact on our overall uncertainty.

So in the short term, rate of returns fluctuates above or below the mean. But not knowing what a meaningful average might be for a given period, we are unsure of whether to enter or pull out of the market. In the long run, the risks lie with our inability to project and assess long-term risks beyond our control, and those beyond our capacity to foresee and project.

This time around, nobody seemed to have been able to project the combustive mix of cheap credit, excessive leveraging, a loose and hardly independent regulatory environment, an over-reliance on faulty maths models, skewed short-term corporate incentive structures, and government legislation that started with nothing but goodwill.

Many people did foresee an eventual combustion.  But the depth and longevity (thus far) of the slump has surprised even some of the most bearish of economists and analysts.

This is but a glimpse of what long run risks could mean.  When a series of short term macro variables snowball into something bigger and more dynamic than we are able to assess from a distance.

picture source: ladyface

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