Why Long-Term Investors Need To Rethink 'Risk'

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

ORIGINALLY WRITTEN BY BENJAMIN GRAHAMOFTEN REPEATED BY WARREN BUFFET, HIS FAMOUS DISCIPLE 

“In the short run, the stock market is mostly driven by demand…..causing over- and under-reactions to underlying fundamentals. But in the long-run, the cash-flows that corporations supply are the ultimate drivers of stock returns.”

FROM “THE LONG-RUN DRIVERS OF STOCK RETURNS:TOTAL PAYOUTS AND THE REAL ECONOMY”PHILIP STRAEHL AND ROGER IBBOTSONFINANCIAL ANALYSTS JOURNAL, THIRD QUARTER, 2017

 

“…..the differences in financing approaches between the base CPP and the additional CPP is the higher reliance of the additional CPP on investment return. Therefore, the additional CPP contribution rates are much more sensitive to investment experience, both negative and positive. In order to mitigate the risk of changes in the additional CPP contribution rates and benefits, it is assumed for the purposes of the 28th Report that the additional CPP assets will be invested in a portfolio that has a lower volatility than the assets in the investment portfolio of the base CPP and hence will generate lower returns.”

FROM THE 28TH ACTUARIAL REPORT ON THE CANADA PENSION PLAN (CPP),OFFICE OF THE SUPERINTENDENT OF FINANCIAL INSTITUTIONS (OSFI), OCTOBER 2016

How Should Long-Term Investors Think About ‘Risk’?

The three quotes above say different things about the relationship between investment risk and time-horizon. Graham, Buffett, Straehl and Ibbotson (GBSI) believe that for short investment horizons, investor sentiment mostly drives stock market returns, while for long horizons, these returns are largely driven by actual corporate profitability and payout policies. In contrast, the OSFI Report implies that return volatility is also a good proxy for long-term investment risk, and that to limit CPP asset exposure to long-term investment risk, accepting “lower returns” by choosing a lower volatility investment policy is a prudent thing to do. Who is right? GBSI or OSFI? Or are they both right? These are the questions this Letter pursues in some detail.