Monday, December 14, 2009

Are stocks more risky in the long term

Are stocks more risky in the long term?

I'd guess that most investors think that stocks are actually safer in the long run than in the short run. This idea is supported by the well known book by Jeremy Siegel.

The intuition is based on a of time-based diversification - in the long run the ups and downs cancel themselves out.

But as Fama and French note, this logic suffers a fatal flaw. This time diversification effect only really works if you know what the true expected return is, and for stocks this is unknown. So, as the time horizon gets longer, you face risk from the volatility of the expected return, and also risk from not knowing what the expected return is.

Is Siegel's book wrong? The answer depends on how you view it. If you read it as a description of how well stocks did over the past 100 years, then it is a great read. If you think it tells us something concrete about the future, then I'd exercise more caution.