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.

RIP Paul Samuelson

The Economist, Paul Samuelson has died. My MBA students will recall his appearance in the "trillion dollar bet" in which he utters the wonderful line that he got Louis Bachelier's Thesis translated from French to English in order to "preserve every precious pearl".

Can you have positive alpha in an efficient market?

Is a positive alpha in an efficient market evidence of illegal activity?

I don't think so. There is nothing in the efficient market theory that says that an investor cannot earn positive alpha. In fact it is entirely possible for an investor to beat the market for many years in a row. Market efficiency just says that the reason for the investor's success was luck, not skill.

Luck vs Skill in mutual fund management

Gene Fama and Ken French show that after you take account of fees, actively managed mutual funds underperform index funds. This is not new news really, but Fama and French present the evidence in an exhaustively robust way. The evidence against active management is very strong.

Felix Salmon summarizes the article nicely here.

Still, most investors will ignore the results of this and other similar studies and chase returns by trying to pick actively managed funds. In the long run they will fail.

FF on duration, term structure and immunization

Great post on the Fama French blog about long term bonds.

Call options and insider trading

My students know that options provide leverage. You don't have to exercise the option to profit, you just need to hold a call option while the stock price goes up. Your gain will be from the increase in the value of the option. My students also should know that insider trading is the practice of making trades based on private information.

So knowing all this, if you knew that HP was about to launch a takeover of 3COM, what would you do? Answer: buy calls on 3COM of course.* Turns out that's what a lot of people did.



*assuming you were willing to risk breaking the law.

Fama and French on portfolio optimization and the equity premium.

Fama and French talk about how to figure out the equity premium to use in a portfolio optimization problem. Excellent stuff and required reading for any finance MBA students!