Pastor: Rethink Stocks for the Long Run - Uncertainty Compounds With Time

Full Transcript:

Consuelo Mack WealthTrack - August 5, 2011

CONSUELO MACK: This week on WealthTrack, Financial Thought Leader and University of Chicago Finance Professor Lubos Pastor has a shocking message for investors. Stocks aren’t necessarily best for the long run. Professor Pastor and his controversial research are next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. We are on Wall Street at the Museum of American Finance. It is the only museum devoted to the history of finance, the core of our free market economy. This week we are examining one of the bedrock ideas of personal finance: the thesis that, over the long term, stocks are safe and rewarding investments. Just about everyone agrees that stocks are volatile and risky over a time frame of five years or less. But widely accepted academic and Wall Street research has shown that when you hold stocks for ten, 15 years, or longer, the risk of owning equities shrinks and the rewards remain large.

That’s the contention of Wharton Professor Jeremy Siegel in his classic study, Stocks for the Long Run . Siegel looked at stock prices and returns in the U.S. stock markets going back to the early 19th century. According to his research, stock investors earned average annualized 7% total rates of return, that’s with dividends reinvested. This bullish analysis of equities has survived even in the aftermath of the financial storm of recent years. Target-date or life-cycle funds are constructed around the idea that stocks are less risky and deliver consistently rewarding returns when held for long periods of time.

But along comes a young University of Chicago professor who has studied the same historical stock data as Jeremy Siegel and has reached shockingly different conclusions. According to Professor Lubos Pastor and his co-author Robert Stambaugh of the Wharton School, the further out you go in time, stocks become more volatile and thus more risky. According to their research, the consistent seven percent returns over the past 200 years are an historical fact, but not a guarantee of the future. Investors looking ahead over the next several decades face all kinds of uncertainty. And as Pastor points out, “uncertainty compounds with time.”

Professor Pastor teaches finance at the University of Chicago Booth School Of Business and earned his PhD at the Wharton School where Siegel teaches. Lately he’s earned a lot of attention for his research on the stock market and asset management. He’s received several top awards from the financial industry, as well as awards for teaching excellence. In a recent interview in Chicago, I asked Lubos Pastor why we should rethink stocks for the long run?

LUBOS PASTOR: Well, the idea of stocks for the long run rests on two main pillars. One is that the average return of those who invested in the stock market has been unusually high, the order of 7% per year in real terms, and the other pillar is that the volatility of stocks declines over time as your investment horizon increases. I have problems with both of those pillars.

CONSUELO MACK: So let’s talk about the returns, because there are many models that we are shown that guarantee us practically that we’re going to get, you say 7% real returns, and I would say, you know, they talk about 10 to 11% nominal returns. Why are those suspect?

LUBOS PASTOR: Well, they did happen in the past, but there is no guarantee they will happen in the future. In fact, I expect the average return in the stock market to be lower going forward than what we have seen over the past couple hundred of years.

CONSUELO MACK: Why?

LUBOS PASTOR: The most important reason in my opinion is that we got lucky. We got tremendously lucky over the past couple of centuries. Imagine someone sitting there in 1800, or 1900, it doesn’t matter. Could that investor have reasonably expected that the United States would become the world’s biggest super power, that the U.S. would win World War I, and World War II, and the Cold War, and avoid the nuclear missiles that Khrushchev sent to Cuba, and not to descend into socialism, as many other countries have. This is all good news, these are all good things that have happened, and they prop the equity returns upward. Going forward, it’s going to be harder to deliver these positive surprises. Once you’re at the top it’s hard to rise even further.

CONSUELO MACK: You know, you bring up an interesting point, actually, because we talk a lot on WealthTrack about global investing. It’s no longer U.S.-centric, and so in fact, the statistics that they were looking at, that have delivered the 7% real returns over the last 200 years are all based on a major U.S. stock market and markets. So in fact, in a global environment, that adds an entire other dimension, doesn’t it, for global investors?

LUBOS PASTOR: It sure does. I am a big fan of international diversification and global investing. I will note that pretty much as you pointed out, if you invested in German stocks, or Japanese stocks, you would have been wiped out after World War II. This did not happen in the United States. So, again, there is a reason why the U.S. stocks have returned a little bit more than stocks elsewhere.

CONSUELO MACK: Now, let’s talk about the risk, the second part of the two pillars that you disagree with, and that is that stocks over the long-term really are not that risky. You say they are risky. Why?

LUBOS PASTOR: Well, I have this recent study, co-authored with Rob Stambaugh from Wharton in which we question the conventional wisdom that stock volatility declines with the investment horizon. If you look backward, look at historical estimates of volatility, you do see strong mean reversion in stock returns, you do see bull markets followed by bear markets, bear markets followed by bull markets, and you do see long-run volatilities of stocks being lower than short-term volatilities. However, we look at this problem a little differently. We compute measures of volatility that look forward as opposed to backward. We take the perspective of an investor who is looking into the future as opposed to a historian who is looking back. See, an investor who looks forward has to take into account not only historical estimates, but also the uncertainty associated with those estimates, and once you take that uncertainty into account, you discover that stocks actually become more volatile on a per year basis as the investment horizon increases.

CONSUELO MACK: So you personally have reassessed your view of stocks in your portfolio as a result of your research. How do you view stocks, what place do they have in your portfolio, and how should we view stocks in our portfolio going forward?

LUBOS PASTOR: I think stocks should remain an integral part of any long-term diversified portfolio. There is no question about that. What I’ve learned from my own research is that stocks are actually more volatile than I thought from the perspective of a long horizon investor. So I personally have slightly reduced my own stock allocation. I haven’t reduced it too much because of my own personal circumstances. I have a lot of human capital that looks like a bond.

CONSUELO MACK: In that you’re a tenured professor at the University of Chicago.

LUBOS PASTOR: I’m a tenured professor, my paycheck is steady, so my human capital looks a lot like a bond. I’m sitting on this huge bond investment, so any modest financial capital that I have should be tilted towards stocks. And there is a broader point here. I don't think everybody should be investing in the same way. Your circumstances are different from mine. Some people’s human capital looks a lot more like a stock, and they should tilt away from stocks in their financial portfolio.

CONSUELO MACK: So, a for instance, I mean, whose human capital, whose job profession looks more like a stock?

LUBOS PASTOR: Take an investment banker who will get a huge bonus in a strong stock market when deals are getting done, but who might get fired in a bad market when no deals are getting done. Take an entrepreneur. These are examples of jobs that do not provide a steady stream of income. This income is highly correlated with the performance of the stock market. So if I were a banker, if I were an entrepreneur, I would be even more cautious with my stock allocations.

CONSUELO MACK: Let me ask you about the risk profile of stocks. So what you’re saying is that stocks are more risky than the conventional wisdom, as, for instance, published by Jeremy Siegel at the University of Pennsylvania at Wharton. How are stocks’ risk profile compared to other assets that we can invest in?

LUBOS PASTOR: So our research focuses specifically on stocks. We chose stocks because that’s where we are able to question the conventional wisdom. We do not analyze bonds, nominal bonds, for example. That would require a different set of analytical tools. However, I do believe that some of our ideas would also make bonds look more volatile in the long run. These are conjectures, but I believe that as long as you’re uncertain about future inflation, that’s going to make bonds look more volatile, as well, going forward. We do have some prescriptions, though, in terms of portfolio allocations, so for example, suppose you’re investing over 30 years, and you’re deciding between two assets, the stock market and a risk-free asset, which over 30 years I suppose would be TIPS, Treasury Inflation Protected Securities with 30-year maturity. In that case, what I would do is reduce my stock allocation, and shift some money over to TIPS.

CONSUELO MACK: So let’s talk about the target date funds, because some of the target date funds have actually, when you near retirement, they actually still have a pretty hefty percentage of the target date portfolio invested in stocks, and because of the attributes that I’ve mentioned, is you still need a growth vehicle for 20 or 25 years of retirement. So do you agree or disagree, or what’s your view of what sort of allocation you should have in retirement to stocks?

LUBOS PASTOR: I personally would be a little bit more cautious with my stock allocation at age 65 when I might retire, because at that point, suppose I commit to retirement, and I will never work again, at that point my human capital is zero for all practical purposes. I’m not going to generate any more paychecks after age 65, so it’s going to be harder for me to make adjustments. At that point, I will not be able to postpone my retirement anymore, it’s going to be harder to cope with the risk involved in stock investing, so I would prefer my investment to be lower than say 35 or 40% in stocks, which we often see at retirement in these target date funds. What I would also like to do, after I retire at some point, hopefully far down the road, is maintain my stock allocation reasonably stable over time. I would not want my stock allocation to continue declining after retirement.

CONSUELO MACK: So this idea that your age should equal your bond allocation, if you’re 75, you should have 75% in bonds, 80, 80% in bonds. You don’t agree with that. At some point you have it level out. At what level, though?

LUBOS PASTOR: I agree with that advice before retirement, because younger people have more human capital than older people, for that reason, but after we retire the human capital is off the table. Human capital does not change between ages 66 and 76. So after we retire, the only justification I see for this declining light path that you’re describing is mean reversion, and stock returns, and again, I’m not a big fan of that argument based on this research that we recently did.

CONSUELO MACK: So if you’re 80 years old, how much should you have in the stock market? Just the average person.

LUBOS PASTOR: You should have something in the stock market, if anything, for diversification purposes, but I certainly wouldn't hold 40% of my wealth in stocks- 10, 20.

CONSUELO MACK: Right. But it should definitely decline with age, and then have a constant, but at a lower level than we probably have been advised to in the past?

LUBOS PASTOR: That’s what I would do, yeah.

CONSUELO MACK: Okay. You know, let me ask you about diversification, because you just mentioned it. That’s another investment mantra is that you should be broadly diversified, that it’s going to protect you in the event of financial crisis, or recessions, or whatever, and as we all know, that it did not protect us except unless you were in cash and gold in the financial crisis. So what’s your view of diversification now? How important is diversification for most of our portfolios?

LUBOS PASTOR: Despite the financial crisis, diversification remains important. See, it would be naïve to think that diversification can protect you from all kinds of accidents. Let me give you an extreme example. Suppose our planet gets hit by an asteroid. Correlations will go to one. That’s pretty clear. Now, suppose we get hit by a really serious financial crisis, as we did in ’07, ’08. Correlations will go to one. That’s not surprising. But diversification does help smooth things out in more normal periods. I mean, think of it as a seatbelt, for example. You put on your seatbelt, it makes you safer in many accidents, it will protect you in many accidents; it will not protect you in really big ones.

CONSUELO MACK: So let’s talk about illiquidity, because you have some lessons from the financial crisis that I’d like to ask you about, and one of them, of course, is liquidity risk, which is liquidity just completely dried up during the financial crisis; and there is also something called “tail risk”, that you have been familiar with for many years, but those of us who are not in your position as a professor at the University of Chicago, didn’t really pay much attention to tail risk, which means on either end of a spectrum, these very unusual events that can happen, either on the positive side or the negative side. We went through negative tail risk. So what were the lessons that you learned from the financial crisis?

LUBOS PASTOR: Certainly liquidity risk and tail risk would be very high on my life. Let me begin with tail risk. Yes, people underestimated tail risk before the financial crisis. Post-financial crisis people pay a lot of attention to tail risk, and as a result, insurance against tail risk is extremely expensive. We cannot all buy insurance against tail risk. For every buyer of insurance there is a seller. So if we all want to buy insurance against tail events, we’re going to end up paying a lot. The price will skyrocket, as it has. To some extent, the high levels of gold that we see can be viewed as, I mean, there are other reasons, but gold is also a good diversifier in times of trouble. Gold can be viewed as insurance against tail risk. Perhaps that’s why investors are willing to pay much for gold. Perhaps that’s why investors are willing to pay so much for T-bills. They are also a good diversifier in times of trouble, good insurance against tail risk.

CONSUELO MACK: Do you think they’re worth the price?

LUBOS PASTOR: Not to me. Not to me, which brings me to my key point. In my opinion, whether or not you should buy insurance against tail risk depends on your own personal profile. If you are in a good position to bear tail risk, if you’re a deep pocket investor, or if you have stable income, you should not be buying insurance against tail risk, you should be selling that insurance because you’re getting compensated for providing this insurance. You’re getting compensated much more handsomely than you would before the crisis. So this is something that I don't see appreciated very much out there. Everybody talks about tail risk, how we have to adjust our portfolio strategies and pay more attention to these tail events. Well, if you buy insurance, I guess, then you’re going to pay a lot. That’s going to be reflected in lower returns going forward. If you’re Warren Buffett, if you’re a deep pocket investor, well diversified, you’re probably better off selling insurance against these tail events, especially today.

CONSUELO MACK: Liquidity. What are the lessons that we should take away from financial crisis about liquidity, or lack thereof?

LUBOS PASTOR: Well, liquidity can dry up, and investment strategies that try to exploit the illiquidity premium get hit especially hard.

CONSUELO MACK: So is there still a lot of systemic risk to liquidity drying up, do you think? I mean, we’re hoping that we’ve learned our lessons, at least the institutions that had the issues with liquidity, that they’ve learned lessons; but is the risk still with us?

LUBOS PASTOR: I think so. I think so. It’s very difficult to predict liquidity crises. It’s not much easier than predicting earthquakes. Liquidity crises and earthquakes are sort of similar: they’re very hard to predict, and when they hit, they hit hard. What we can do is position our portfolios to be prepared for the next liquidity shock. Even if we can’t predict it, we can manage the portfolio so that the portfolios drop in times of liquidity crisis is not too happy.

CONSUELO MACK: And how do we do that? How do we protect our portfolio against liquidity drying up?

LUBOS PASTOR: Well, we would want to stay away, or reduce our holdings in assets that fall the most sharply, when liquidity dries up. I would call these high liquidity beta assets.

CONSUELO MACK: And those are?

LUBOS PASTOR: And those are bank stocks, junk bonds. You can measure these sensitivities to liquidity shocks, and you can sort assets based on how sensitive they are to liquidity fluctuations.

CONSUELO MACK: As far as active versus passive management, we’ve had a number of people on WealthTrack- you know, Burton Malkiel, for instance, A Random Walk Down Wall Street, Charlie Ellis, who wrote, you know, Winning the Loser’s Game- who are very firm advocates, proponents of index investing, because they feel that their research has shown them, and their experience has shown them that the active managers cannot outperform the index over long periods of time. What’s your view in the active versus passive debate?

LUBOS PASTOR: Having looked at the data myself, I agree with those who find that most active managers have been unable to outperform passive indices. Roughly two-thirds of active funds underperform passive benchmarks, and...

CONSUELO MACK: Over time?

LUBOS PASTOR: Over time. And the one-third that outperforms varies from one year to the next. It’s really hard to pick the outperforming managers. So if you’re picking at random, you’re likely to be better off with a passive index. Now, having said that, I do believe there is some talent. If you have access to the top managers, if you are David Swenson of Yale’s endowment, and you have access to the top private equity funds, to the top hedge funds, I think you can be passive indices. It’s just that very few of us are in that position. I also believe that there is some talent, there is some skill in active management. You’re more likely to find it in the neglected and less liquid asset classes.

CONSUELO MACK: Small cap?

LUBOS PASTOR: Small cap, private equity. You’re more likely to find it there than in the most liquid asset classes, large cap or treasury bonds.

CONSUELO MACK: So your advice, then, to individual investors who wish to be invested in the markets is to do index funds?

LUBOS PASTOR: If you can get access to top performing managers, and if you are pretty sure they are top performing managers, go for it. If you’re not in that position- and most people are not in that position- I would go with index funds.

CONSUELO MACK: Why in finance, investing the one area where we can’t excel, we can’t beat the averages consistently?

LUBOS PASTOR: Because markets are awfully close to efficient. They’re not perfectly efficient. You have superb hedge fund managers who find inefficiencies- from their perspective, markets are not efficient. From the perspective of the average guy out there…

CONSUELO MACK: The average portfolio manager, in other words.

LUBOS PASTOR: Even the average active, from the perspective of the average mutual fund manager, say markets are awfully close to efficient.

CONSUELO MACK: So their playing field is so efficient that there’s no way you can beat it consistently.

LUBOS PASTOR: Moreover, the average investor holds the stock market, there’s no way around that. Each stock out there is held by someone. The average investor-- if we were to put together all of our holdings and put them into one person, that investor would be holding the valuated, diversified stock market portfolio. So if Bill Miller tilts in the direction of value, somebody else must tilt in the direction of growth. If I tilt in the direction of small cap, somebody else must tilt in the direction of large cap. Otherwise things wouldn’t add up. So given that the average investor holds the market portfolio, for everyone who outperforms, there must be someone who underperforms.

CONSUELO MACK: I hope to not be in that group.

LUBOS PASTOR: So then you have to ask, active versus passive- the passive guys pay very small fees. We find the passive, my fees are 10, 20 basis points; if I hire an active manager, we’re talking about ten times higher fees. It’s pretty much a zero sum gain, so if I’m a zero sum game, I’d prefer paying lower fees. I think it’s as simple as that.

CONSUELO MACK: So that was succinctly put. So the real proof in the pudding is always what you’re doing with your modest investments, as you put it. Are you indexing, or are you investing it with active managers?

LUBOS PASTOR: I am indexing my modest financial portfolio.

CONSUELO MACK: Right. So you’re definitely following your own advice. One Investment for long-term diversified portfolio- we always ask everyone this on WealthTrack, and you actually have an unusual one.

LUBOS PASTOR: Yeah, it’s hard for me to give financial advice. I don't follow large cap, small cap, et cetera, value versus growth. I’ve mentioned human capital earlier, and I believe that investment in human capital is particularly important these days. Investments in financial assets, wherever I look I see low yields- I see low yields in bonds, I see stocks being sort of pricey, I see commodities being expensive. I look at human capital and I see high returns with very little downside risk. If you invest in your education, for example, especially as a young person, you’re getting a high expected rate of return with virtually no downside risk, and potentially huge upside risk.

CONSUELO MACK: But let me ask you about that because, for instance, if you go to college, or if you get a graduate degree, most students’ parents are unable to afford the very high price, so you end up being indebted. I mean, some students are graduating from graduate school with $100,000, $200,000 debts. You still think that that is a good investment?

LUBOS PASTOR: I believe that it’s a good investment, especially for the very top schools. So due to globalization, we live in a society where income and equality is higher than ever before. This is a society where there are billions of people in emerging markets, China, India, elsewhere, willing to work hard, willing to join the global labor force. You have to compete with them. You need something that they don’t have, and top level education delivers that, delivers skills. You can get unique skills that you can’t get elsewhere.

CONSUELO MACK: So invest in yourself. That’s probably a very good piece of advice. So Professor Lubos Pastor, thank you so much for being with us on WealthTrack. We really appreciate our conversation with you.

LUBOS PASTOR: Thanks for having me.

CONSUELO MACK: Financial Thought Leader Lubos Pastor- it’s definitely worth following his advice and heeding his ground breaking research.
The next couple of weeks are fundraising periods for many public television stations, so be aware that WealthTrack might not be seen in your area. However, for those stations that do show us, we’re going to replay an interview with that eloquent contrarian and Financial Thought Leader, Jim Grant. Jim is a much read journalist, historian and editor of Grant’s Interest Rate Observer who has some fascinating thoughts about inflation and Federal Reserve Policy.
Meanwhile to see this program again, please go to our website, wealthtrack.com for a podcast or streaming video. And while you are there, check out WealthTrack Extra, where you can find complete, extended interviews with recent guests, including our TV exclusive with retired PIMCO Great Investor, Paul McCulley.
Thank you for taking the time to visit with us. Make the week ahead a profitable and a productive one.