5. Investing in Financial Markets: Empirical Evidence

Question 1

5.1. What is mean reversion?

Answer 1

Mean reversion: returns can be unstable in the short run but stable in the long run.

Question 2

5.1. In the log-term what has been the performance of stocks compared to bonds?

Answer 2

In the long-term stocks dominate bonds:
- In the short-term, stocks are riskier
- In the long-term, stocks have less risk.

Question 3

5.1. What has been the impact of the change in the monetary standard from gold to paper?

Answer 3

The change in the monetary standard from gold to paper had a great impact on:
- Inflation
- The returns of fixed-income assets

Question 4

5.1. Comment the statement: “Bondholders accept to hold assets with very low real returns”.

Answer 4

I agree with the affirmation. Indeed, Bondholders accept to hold assets with very low real returns, because:
- Buyers of long-term bonds in the 1940s, 1950s, and 1960s did not recognize the inflationary consequences of the change in monetary regime (monetary illusion)
-Traumatic effect of the Great Depression on the equity investors
- Fear that another depression would follow the war

Question 5

5.2. The safest long-term investment for the preservation of purchasing power has been …

Answer 5

a diversified portfolio of equities.

Question 6

5.2. According to Siegel (2007), history has shown that…

Answer 6

Unless investors believe there is a high probability that they will need to liquidate their savings over the next 5 - 10 years to maintain their living standard, there is no compelling reason for long-term investors to abandon stocks no matter how high the market may seem.

Question 7

5.2. The standard deviation of stock returns is higher than the one for bonds over …

Answer 7

Short-term holding periods.

• Once the holding period increases, the standard deviation of average stock returns decreases, and stocks become less riskier than bonds.

Question 8

5.2. What is the result of the mean reversion effect on the standard deviation of stock and bond returns?

Answer 8

• Historical data show -that the actual risk of stocks declines far faster than the predicted rate (random walk theory predictions).
• The actual risk of bonds and bills does not fall as fast as the random walk theory predicts.

Question 9

5.2. Describe the correlation between stock and bond returns as a measure of diversification.

Answer 9

If bond and stock returns are negatively correlated, bonds may still serve to diversify a portfolio and lower overall risk.

Question 10

5.2. Recommended portfolio allocations: what percentage of an investor’s portfolio should be invested in stocks?

Answer 10

Regarding recommended portfolio allocations:

• The answer depends on the investor’s risk tolerance and the holding period.
• The recommended equity allocation increases dramatically as the holding period increases.
• Even conservative investors should hold nearly 90 percent of their portfolio in stocks over 30-year holding periods.
• It is puzzling that the holding period has almost never been considered in portfolio theory, because under random walk, the relative risk of various securities does not change for different holding periods but is crucial with mean reversion.