Here are some highlights from the paper.
The lowest risk asset
Of course, Social Security and real life annuities are relatively close substitutes for the perpetuity, but real life annuities can no longer be purchased in the US and perpetuities don’t exist.The [inflation] indexed perpetuity is the riskless asset for a long-run investor. Stop and savor that statement. I remember first seeing the paper when in 2001 John [Campbell] gave it at Chicago. I instantly thought, “This is obvious.” And then, I realized that neither I nor anyone in the room knew it. That’s brilliance. Now, the statement is only obvious if you look at the payoffs. An indexed perpetuity gives a steady stream of income forever. It’s the risk-free payoff. Duh. …
This verity is not at all obvious to the investing world. The idea that indexed perpetuities are the risk-free asset meets incredulity. How many MBA investment classes yet mention this obvious fact, instead calling money market funds the “riskless asset?” (Mine did, after 2001, but I wonder how many of my ex-students remember the proposition.)
Stocks and the long-term investor
HousesNow, many risky investments, including stocks, are a lot like bonds – low prices correspond to high expected returns, not low expected cash flows. Much price variation is discount rate variation, and more so at high frequencies. …
This fact means that stocks are not as risky for long-term investors as one might think. How can we express that fact? Why don’t we say that stocks pay a much steadier stream of dividends than the volatile prices might suggest? [L]ow prices without a change in dividends, do not signal lower dividends ahead, so the strategy of just holding the stocks and eating the dividends is relatively safe.
Risk aversionHouses may be a good example halfway between stocks and bonds. House prices vary a lot. Yet most of us do not market-time housing. Yes, the transactions costs are larger. But the main reason is, we have to live somewhere. The house you want to buy goes up just as much as the house you want to sell. Houses are perfect hedges for house-price investment opportunity variation. Indeed one of the major benefits of buying a house is that you are protected from rent variation, and can live there as long as you want no matter how high rents go. A house is an indexed housing perpetuity.
Link to paper - https://www.johnhcochrane.com/research- ... portfoliosIf investors are to answer “What’s my risk aversion?” – tell us γ in w= (γΣ)−1μ– it’s awfully hard to come up with a number. Various surveys and questionnaires to elicit such a number are only fodder for behavioral finance in their inconsistency. Like rats in a maze, we are as-if maximizers not self-aware calculating automatons. But if investors have only to answer,“Are you more risk averse than the average investor?” perhaps we can make progress. Of course, beware surveys. Not everyone can be less risk averse than average either! And people who state low risk aversion in good times have a remarkable habit of changing their minds in the tough after-the-big-loss meetings with their managers.
BobK