Yogi Berra, the legendary baseball player who passed away last year once said: "In theory there is no difference between theory and practice; in practice there is." This witty statement accurately describes the occurrences in the investing world, in general, and particularly in the equity markets.
The economic theorem which, by its nature, defines situations in formulaic forms, is applied in the investing world in a broad and generalized manner. The CAPM (Capital Asset Pricing Model) is predicated on the fact that in order to receive higher returns in the stock market, one must take on more risk. The specific risk attributed to a stock is determined by its beta -- a ratio which reflects the volatility of a stock in relation to the broader stock market. In other words, the higher the volatility in the stock's price in relation to the broad stock market (both upward and downward volatility) -- the higher its beta will be, and the higher the perception of its riskiness by financial experts.
However, a more in-depth analysis of this data reveals that the rigid use of the beta factor may lead to inappropriate financial decisions. The main flaw associated with the rigid interpretation of beta is the ignoring of the economic value of the company at hand. For example, let us assume that a company owns assets valued at $100, and the company's stock reflects this exact value on a certain day. Let us further assume that a year later the stock market in which this stock trades is 10% lower while this specific stock has fallen by 20%, but without material change in its assets (a common occurrence in the volatile stock market).
The use of factor beta (the value of which will rise due to the volatility of the company's stock value in relation to the stock market) will define this stock as "riskier" than at the beginning of the year. This will occur despite the fact that at the end of the year we can purchase the company's stock and obtain assets valued at $100 at a discounted price of $80. This kind of skewed logic would lead us to believe that purchasing a basket of goods at the supermarket at a discounted rate of 20% is a bad deal…
The investment guru, Warren Buffett, once stated that "I'd be a bum on the street with a tin cup if the markets were always efficient." Buffett has accumulated his fortune by adhering to principles which are the exact opposite of those adopted by the theorists. He understood that the real risk was not in the volatility-related high beta value of a company's stock but rather in paying too high a price for this stock. Buffett has taught us that the volatility in the stock market is not a reason to back off from this market; on the contrary, investing in the appropriate stocks may create a major opportunity for significant profits.
Despite the short-term volatility of the stock market, the only investment path that displays a long-term upward trend is the stock market. Various investment paths which are considered "less risky," such as cash, bonds, real estate and commodities, are poor long-term investments due to inflationary pressures, changes in demand, and mainly because they do not enjoy the benefits of compound interest which exists in the stock market. For example, a person who was clever enough to invest $10,000 in Berkshire Hathaway in the 1960s when Warren Buffet acquired the company, has turned his investment to $180,000,000 today (CAGR nominal rate of above 20%). The same amount invested in a total return S&P fund would be worth about $3,000,000 today (nominal rate of about 10%). Investing the same amount in 10 year U.S treasuries would have yielded only $200,000 today (nominal rate of 5%).
The conclusion from the discussion above is that for long-term investments (approximately 5 years and above), the stock market is the preferred vehicle of investment despite its inherent volatility. Patiently holding a basket of stocks (chosen after careful analysis of their characteristics or by utilizing various robust quantitative strategies) for a long period of time, without frequent and flippant changes to the portfolio, will result in a very high return over time.
These data and considerations receive increased importance in view of the difficulties pension plan managers confront in achieving significant returns in today's low yield environment. Under such circumstances, every long-term investment manager, in particular every pension fund manager, should increase the share of stocks in the investor's portfolio.
Such a change in the nature and path of pension monies investment raises two questions. First, what guarantees that stocks will continue to yield high returns in the future? Second, what if a downturn of the stock market occurs at the exact time when an investor needs to withdraw his pension savings.
The answer to the first question is that as long as no apocalyptic event affects the world economies, stock values will continue to reflect economic progress and will correspondingly continue to rise. Moreover, it is the perceived risk associated with the investment in stocks that will continue to result in higher returns for stocks (as a compensation for this perceived risk) -- the so called equity premium.
The answer to the second question revolves around the fact that pension funds are designated solely for long term investment. Hence, pension funds invested in stocks for long periods of time and generating highly fruitful returns over the years will result in such high sums of money in the investor's portfolio at the time of his retirement, that even a marked downfall in the value of the stocks will leave the investor with a significant sum.
Today's long life expectancy further underlines the importance of high exposure to equities at advanced age in order to preserve quality of life into the golden age. Such a policy (which contrasts with the traditional/conservative approach of decreasing exposure to equities with advance age) is supported by two recent studies published in the American Association of Individual Investors (AAII) Journal (Kitces M. et al, 4: 7, 2014 ; Delorme L. et al, 9: 15, 2015) . These studies found that a gradual increase in the exposure to equities in the portfolio of an investor at retirement age, is the optimal allocation strategy.
The managers of pension portfolios should distance themselves from short-term considerations and from efforts to beat competitors in a given month. These managers should instead focus on identifying stocks of companies that will yield above-market returns over long periods of time, and on rational use of the stock market with the purpose of generating significant long-term revenues for young and old investors.
Disclosure: I am/we are long BRK.B.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.