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The second way of demonstrating the risk factor is to note standard deviations for investments in stocks, bonds or Treasury bills. The first are in principle riskier than the second, which are in turn more risk fraught than the third. Once the holding period lengthens, the variability of these three types of assets tends to diminish. For a one-year investment the standard deviation was 18 percent for stocks, 9 percent for bonds and 6 percent for Treasury bills. The standard deviation for equities fell to 12 percent for two years, to around 8 percent for five years, to slightly more than 4 percent for ten years and to 2 percent for twenty years of holdings. Over twenty years the risk associated with stock investment becomes even less pronounced than that associated with bond investment; over thirty years, stock volatility is a third less than that associated with Treasury bills.
If one sticks to stocks for a sufficient amount of time, the returns on such an investment grow less and less subject to chance. Little by little, they go back to the statistical average. Their behavior is that of a parameter gravitating around its average value and never cumulatively breaking away. Think of a rubber band that may be stretched to a certain point and yet never snaps. The longer the duration of the investment, the less the pressure put on the rubber band, that is the less returns vary or depart from the norm. In contrast, the longer one remains invested in fixed-income instruments, the more the volatility of real returns grows. In fact, this divergence betrays a tendency of cumulative distancing from the average.
The deviations of these quantitative instruments are explained by the negative cumulative influence of inflation on the reward for investing. The disastrous real returns on German state-issued bonds in the 1920s and on Japanese state-issued bonds following the Second World War correspond to periods of galloping, double-digit inflation in the two countries. These are also to be found – but to a lesser degree – in US and UK government bonds dating from the 1970s. Once inflation picks up, the process becomes cumulative and bond investors have no chance to compensate for the loss in purchasing power by dint of returns on their investment. Quite the opposite, inflation penalizes long-term securities and increases nominal interest on new ones. This helps to explain the cumulative distancing from the average that characterizes fixed-income instruments. Risk measured in terms of volatility goes down as investment duration lengthens. It nonetheless seems to be the case that risk pertaining to the riskiest of assets diminishes more rapidly as time goes by than is the case with those entailing minimal risk. The more the investment duration lengthens, the fewer the risks presented by a given security. What appears paradoxical is that while volatility is calculated in terms of yearly rates of return, it in fact diminishes the longer the investment lasts. Yet investment horizons play a prominent role in the evaluation of risk. Institutional investors are judged in terms of their monthly performances. Retired people may well require a steady monthly income. Forty-year-olds readying themselves for retirement are thinking of terms of a twenty-year horizon. From their point of view, price variability does not constitute a risk factor. Given the period of time involved, for them stock volatility amounts to next to nothing. The way volatility is measured does not take this into account. The above analysis, according to which stock market investment over a sufficiently protracted length of time always turns out to be the best, has led some commentators to wonder why there should be a risk premium that would compensate an investor for the risks incurred on his portfolio of stock. The historical variability of prices, that is the amplification of market variation, is certainly one component of risk. As we have already seen, volatility is a risk for the investor who may be compelled to sell off his shares at a time not of his choosing, for example when the market is in the throes of a crisis. But in that case, why is there a risk premium for stock investment when waiting long enough means playing it safe? Why does the market require higher returns on stocks than on bonds, even though the former turn out, in the long run, to be more profitable than the latter? The same reasoning may be applied to specific risk: it can be eliminated through diversification; it need not be remunerated by the market. Why, to put it briefly, should the market remunerate the evanescent risks incurred by stock investors? Let time pass and your investment becomes less a Pascalian wager and more a minutely calculated risk; elapsed years ensure a form of diversification. No premium appears to be called for.
That is one of the explanations put forward for stock market rises occurring during the bull market at the end of the 1990s. Investors apparently agreed to buy high-priced stocks because they were resigned to rather low returns on their investments. Hoped-for profits would be low, as were interest rates; the risk premium was all but negligible. The disappearance of the latter may be explained by statistical analysis demonstrating that that waiting game pays off; returns on stock investments are bound to overtake those obtained by bond or Treasury bill investments. And yet, polls performed at that era showed that institutional investors were aiming for risk premiums of an average of 4 percent, a figure aligned to historical averages of great duration. The one other explanation would consist in claiming that investors were expecting ever-higher profits amounting, as subsequent developments would make clear, to ‘‘pie in the sky’’. In reality, stock investment had grown more risky; investors should have insisted on a heightening of their risk premium. At that time Caps, a consultancy for British-based pension funds, had demonstrated that from 1995 – 2000, stock market volatility had been twice that of the preceding five years (1990 – 95). Yet the real return from investing in equities had been halved over the same period. The fact is that investors had not taken into account the risk increase accompanying the price increase. Had they been more perspicacious, the bubble could not possibly have been formed. In the long run – but one must wait 15 or 20 years – volatility tends to disappear and the risk premium should no longer exist. Long-term investment is an investment in the market, in a portfolio that faithfully reproduced market variations. Long-term portfolio risk gradually diminishes, so CAPM does not apply. For short periods (three to five years), investments are performed on the basis of growth prospects and not as a function of volatility. In the short term, there is no required rate of return, no long-term analysis, no fundamental valuation; all value is marked in the daily revaluation of the stock exchange. And so, rather paradoxically, CAPM could be utilized neither for the long haul nor the short term. It nonetheless constitutes an irreplaceable analytical framework when establishing anticipations.