The good, the bad and the mean

By David McEwen

Monday 6th May 2002

One popular rule of thumb about asset allocation is that the further into the future you expect to cash up your investments, the more you should put into shares.

That's because shares generally deliver a better return than other asset classes but also more volatility. Those with a long-term outlook can afford to ignore short-term ups and downs in the expectation that, over time, markets always go up.

That's the accepted theory at least. However, new research by Nicholas Barberis, associate professor of finance at the University of Chicago, indicates the link between time and returns are not as large as people think.

He studied the concept of mean reversion, where people believe share markets eventually always return to a 'normal' valuation after long periods of rises and falls.

"There's this popular advice that people who have many years left to live should put more of their money into stocks. Because there's some mean reversion in stocks, in the long run, they're not that risky," he said recently.

But his study of the US share markets over many decades found that "the evidence of cycles in the stock market is actually very weak."

The good news is that his research found that long-term investment in the share market still makes good investment sense. However, it is not as safe compared with short-term investments as many people think.

"I found that people with a 20-year horizon would want to put 15 percent more into stocks than people with a one-year horizon, which is a lot less aggressive than some advisers recommend," he said.

The weakness of the mean reversion evidence also means that people should be careful in timing the market. A rising or falling market isn't automatically going to correct back to its mean point.

Professor Barberis considered the following scenarios:

- Buy and Hold
This is where an investor with a long term viewpoint chooses how much of their portfolio will be allocated to shares and does not touch the portfolio again.

- Myopic Rebalancing
In this scenario, an investor rebalances the portfolio at set intervals, for example every year. If the value of the share portfolio has risen faster than the other asset classes to where its weighting in the portfolio is higher than originally set, then shares are sold to take the weighting down. This is repeated each year. This is called a myopic strategy because the investor does not use any new information, such as changing interest rates, to adjust their portfolio.

- Optimal Rebalancing
This is where the investor chooses an allocation today and adjusts it each year according to new information or changed circumstances.

Regardless of which strategy is adopted, the results were the same - holding shares long-term is still better than short-term, but not massively so.

His findings seem to in keeping with research that finds the best way to grow your wealth is by picking the right time and right asset class to invest the bulk of your funds into.

Professor Barberis recommends a cautious approach is taken when dividing up your portfolio between the various asset classes - defined as cash, bonds, shares and property. Investors should not load up on shares too much in the expectation that time will produce the goods for them.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

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