Thursday, February 26, 2009

If this is true we are REALLY in trouble

Pastor and Stambaugh in a new NBER working paper argue that, contrary to received wisdom, stocks are actually more volatile over long horizons than over short ones. Here's their abstract:

Conventional wisdom views stocks as less volatile over long horizons than over short horizons due to mean reversion induced by return predictability. In contrast, we find stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. We decompose return variance into five components, which include mean reversion and various uncertainties faced by the investor. Although mean reversion makes a strong negative contribution to long-horizon variance, it is more than offset by the other components. Using a predictive system, we estimate annualized 30-year variance to be nearly 1.5 times the 1-year variance.

Here is an interesting paragraph, raising a point I had not thought about before:

Of the four components contributing positively, the one making the largest contribution at
the 30-year horizon reflects uncertainty about future expected returns. This component (iii) is
often neglected in discussions of how return predictability affects long-horizon return variance. Such discussions typically highlight mean reversion, but mean reversion—and predictability more generally—require variance in the conditional expected return, which we denote by ut . That variance makes the future values of ut uncertain, especially in the more distant future periods, thereby contributing to the overall uncertainty about future returns. The greater the degree of predictability, the larger is the variance of ut and thus the greater is the relative contribution of uncertainty about future expected returns to long-horizon return variance.

here is the link to an ungated version of the paper

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