Morningstar Advisor - December 2013/January 2014 - (Page 66)

Gray Matters Optimal Portfolios for the Long Run By David Blanchett Our study shows that equity risk declines as time horizon expands. There is surprisingly little agreement among academics about the existence of time diversification, which we define as the anomaly where equities become less risky over longer investment periods. The primary critique of time diversification is theoretical and the primary defense empirical. Samuelson (1963) and Bodie (1995) pointed out that if stocks are less risky in the long run there is a free lunch for long-run equity investors. Bodie (1995) emphasized the fact that time diversification violates the Black-Scholes option pricing model. If time diversification exists, then options hedging long-run equity risk should reflect a decreasing likelihood of loss over longer time periods (they don't).1 Campbell and Viceira (2003) argued that empirical evidence shows that stock returns are not independent and identically distributed over time (they tend to mean revert), which implies that long-run stock returns may be predictable and that long-run investors should overweight equities.2 1 Black-Scholes could also be inconsistent with time diversification if security returns don't follow a Weiner or Brownian process. 2 Campbell and Viceira (2003) also note that the mean reverting returns, which are necessary for time diversification, imply that a buy-and-hold strategy is suboptimal. Those who practice time diversification should be aware that the logic which underlies time diversification is also consistent with valuation-based market timing. 66 Morningstar Advisor December/January 2014

Table of Contents for the Digital Edition of Morningstar Advisor - December 2013/January 2014

Morningstar Advisor - December 2013/January 2014
Letter From the Editor
What’s Your Purpose?
Working for Gen Y
How to Allocate College Savings
Mobius Looks to a New Frontier
Investments á la Carte
Investment Briefs
How to Manage Bonds for Today and Tomorrow
Cloud Is the New Engine of Growth
Knowing Where to Look
Economic Vulnerability Varies by Country
Factor Investing in Emerging Markets
Following the Rules
Exploring Indexing’s Next Frontiers
Frequent Fliers
Family Blind Spots
Optimal Portfolios for the Long Run
Finding Value in a Pricey Sector
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Emerging-Markets Roller Coaster

Morningstar Advisor - December 2013/January 2014