Mark Hulbert: Stock market risk is always far higher than you think

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Odds are high that retirees are thinking about risk in exactly the wrong way.

Of course, chances are good that the rest of us are, too. But risk is especially toxic to retirees’ portfolios, since they have a reduced ability to make up for any unexpected losses — either by going back to work or waiting for the markets to recover from those losses.

Consider the range of possible outcomes from just three current geopolitical crises (out of the myriad that could also be chosen): Those involving Italy’s political and economic collapse, a nuclear-bomb-armed North Korea, and a possible trade war. How confident are you that each of these crises will be resolved favorably? And even if those crises don’t cause the financial markets to implode in the near term, how confident are you that decisions being made today won’t have dreadful consequences over the long term?

It’s evident that, when you think about it this way, the range of possible outcomes to each of these crises expands the further out in time we focus. War with North Korea is not likely to happen over the next 24 hours, for example. But over the next decade? Who knows? Some generals rate the odds as high as 40% to 50%.

The same expanding range of possible outcomes exists for Italy’s current crisis or a possible trade war, for any of the other crises that we could rattle off the tops of our heads, and as well for the indefinitely large number of unknown unknowns.

This is at odds, however, with the assumption behind almost all retirement financial planning, that risk diminishes with time horizon — that things will work out the longer our investment horizon. In other words, to use the famous mocking phrase of British economist John Maynard Keynes, is the prediction that “when the storm is long past the ocean [will be] flat again.”

But how do we measure the possibility that the ocean won’t be flat even well after the storm has passed? Two finance professors — Lubos Pastor, a finance professor at the University of Chicago, and Robert Stambaugh of the Wharton School — have devised a novel way, and their findings turn traditional retirement planning on its head. (Readers interested in the statistics underlying their findings should consult their paper directly: Are Stocks Really Less Volatile in the Long Run?)

The longstanding assumption that risk declines as we focus on longer and longer time horizons is, in essence, the notion that there is regression to the mean — that good periods are more likely than not to be followed by poor ones, and vice versa. And there’s no doubt that this is a powerful force. Over the last two centuries, the range of stock market outcomes at the one-year horizon was a lot greater (46 percentage points) than it is at the 30-year horizon (9 annualized percentage points).

To be clear, Professors Pastor and Stambaugh don’t deny that regression to the mean exists in the financial markets, or that it is a powerful force. But their argument is that there are other forces that are even more powerful and that, therefore, more than offset it.

How much does stock market risk grow as time horizon expands, once you take both regression to the mean and these other forces into account? The accompanying chart provides the answer: When moving from a one-year horizon to a 10-year horizon, risk (as measured by the variance of possible returns) expands by around 10%. When moving from a one-year to a 30-year horizon, this variance ratio expands by nearly 50%.

If you have a hard time believing that, just remember the Japanese stock market over the last three decades. The Nikkei 225 Index NIK, +0.61% is currently trading for barely 50% of where it stood 30 years ago. In essence, the professors are arguing, don’t be too confident that the U.S. stock market couldn’t suffer the same fate.

For most of you, however, I bet that in your heart of hearts you already know that the professors are right. We’re unlikely to lose our job tomorrow, just as it is unlikely that the stock market will fall by 50%. But our confidence drops significantly when we expand our focus to what might happen over the next decade — or three decades, for that matter.

Risk grows the further into the future we focus, rather than becoming less.

The investment implication for retirees? You probably should reduce your equity allocation. This is not a market timing judgment, since this implication would be the same regardless of where the stock market stands. But you might find this advice particularly compelling in light of the advanced age of the current economic recovery.

For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.