Stocks are riskier than bonds. Their prices go up and down more. But the longer you hold stocks, the less risky they are."
Statements such as this are a common feature of defined contribution plan educational materials and the marketing materials of many mutual funds.
Unfortunately, they are wrong, and sponsors of many defined contribution plans and mutual fund organizations must rework their educational materials to correct the misinformation. Such statements are dangerous to the fiscal health of plan participants and mutual fund investors who rely on them.
Famed economists Paul S. Samuelson and Robert C. Merton have written a number of articles disproving this piece of common knowledge. Unfortunately, most of these articles appeared before the surge of participation in defined contribution plans in the mid-1980s, so the warnings have gone unheeded.
Now Zvi Bodie, professor of finance at Boston University, has added his voice to those of Messrs. Samuelson and Merton in challenging the idea that the risk of investing in stocks declines as the investment horizon lengthens.
Writing in the May-June Financial Analysts Journal, Mr. Bodie uses a different methodology from that of Messrs. Samuelson and Merton in reaching his conclusion.
Using options pricing theory, Mr. Bodie found the cost of insuring a pension portfolio against not achieving at least the risk-free rate of return (or the return on Treasury securities), rises over time. For example, for a one-year time horizon, the cost of the insurance is 8% of the portfolio value. For a 10-year time horizon, it is 25%. If conventional wisdom about the risk falling over time were correct, the cost of such insurance would decline as the horizon lengthened.
So younger investors shouldn't necessarily put more into stocks than older investors.
Mr. Bodie argues a critical determinant of the optimal asset allocation for individuals is the time and risk profile of their human capital (i.e., the present value of the expected stream of labor income over the working years).
Human capital is a large proportion of total wealth when an individual is young and the proportion gradually declines as the individual ages (because the time horizon of the expected stream of labor income is shorter and other assets are usually larger).
For most individuals, there is some correlation between the human capital and the stock market. And that correlation is higher for some than for others. For example, the correlation is high for young Wall Street executives. It is relatively high also for employees of cyclical companies.
Mr. Bodie argues that for such individuals, starting out with a relatively low commitment to equities and increasing it over time might be the appropriate strategy.
There is no easy solution to the asset allocation problem. The correct asset allocation is not solely a function of any properties of stocks, Mr. Bodie says. It is specific to each individual's situation.
Therefore, all who seek to educate defined contribution plan participants about the relative risks and returns of stocks, bonds and other investments need to rethink their messages.
Happily, Mr. Bodie's current research product may help. He is developing betas for various occupational categories.
