Is it possible that the longer you hold a stake, the greater the risk of holding a stake?
Asking is almost a sacrifice. One of the most basic principles of retirement planning is the exact opposite. In other words, the risk decreases over time. This is a nearly universal source of advice for young adults to invest 100% of their retirement portfolio in equities and gradually reduce their allocation as they approach retirement.
But asking what no one else asks is the job of the opponent, and that’s what I’m trying to do in this column.
To that end, I contacted Zvi Bodie, a 43-year professor of finance at Boston University. Body has devoted much of his career to studying retirement finance issues, and he is contrarian when it comes to the long-term risks faced by equity investors.
In an interview, Body said there was a sense that the general wisdom about long-term risk in equities was right and that it was dangerously wrong. Most people focus on the first and ignore the second.
Feeling that the general wisdom is correct: The longer you hold a stock, the less likely you are to lag behind risk-free rates such as government bonds. As you can see from the attached graph, this has certainly been the case over the last two centuries.
It certainly seems to be a strong support for common wisdom. However, according to Body, what this method of analyzing data overlooks is the magnitude of the loss if the stock lags behind the risk-free rate. And the longer the retention period, the greater the potential loss.
This is a subtle but important point. The probability of loss decreases with retention, but the size of the potential loss increases.
To explain the net effect of these two trends, the body wants the insurer to insure against the possibility of making less than the risk-free rate at the end of a particular holding period. Calculated the amount to be charged (similar to Treasury securities). Of course, with such insurance, you can easily sleep in all your stock portfolios. I know your worst result is at least putting your money into a money market fund.
Please note that no insurance company currently offers this type of insurance. Nevertheless, there is a standard formula for calculating what an insurer needs to claim to guarantee its solvency. Using such a formula, Body found that the cost of insurance increased over time. This can be seen from the attached graph.
This result brought to mind almost all of retirement financial planning, and I wondered what kind of backlash the body received when it was released (for example). Financial Analyst Journal May-June 1995). He couldn’t find a flaw in the body argument, a typical reaction to me (what a famous professor actually told him), but he must be wrong. It was that I felt it.
For the record, Body is still confident that his conclusions are correct. He points out that the late economist Paul Samuelson (and the 1970 Nobel laureate in economics) came to the same conclusion. He called the belief that risk declines over time “dogma.” “Whether you have 15 or 40 years to retire, you can definitely lose, and you can lose a lot.”
Further reinforcing Body’s claim is a study conducted by Rev. Rubos of the University of Chicago and Robert Stanbo of the Wharton School of the University of Pennsylvania. They defined risk in terms of volatility, but came to a similar conclusion, as opposed to defining the body as the potential magnitude of loss. The risk increases with the holding period. (I devoted a column to the work of these two professors Retirement Weekly Column in October last yearSee again for more information. )
Impact on investment
Body analysis means that you can no longer rely on general rules of thumb to determine your stock allocation. For example, one of the most popular such rules was the so-called “100 rules”. According to this, the capital allocation should be 100 minus age. However, the rule no longer makes sense, as the risk increases with retention.
So how should retirees and almost retirees decide on their capital allocation? The body said it needs to be approached from a different angle than as a function of age. Instead, they should start by determining the amount needed for their pension (or functional equivalent) to ensure that their living needs are met no matter what. Only after these basic needs have been met will the risk spectrum of equities, etc. need to be further considered.
Please note that this means that there is no “universal” stock allocation advice. It’s appropriate because it’s a function of basic needs and a reliable income to meet those needs.
Does the risk of a stock increase as the holding period increases?
http://www.marketwatch.com/news/story.asp?guid=%7B83DBE8E0-72BD-11EB-930D-C0E98FAA746F%7D&siteid=rss&rss=1 Does the risk of a stock increase as the holding period increases?