There are all sorts of examples in the investing area of claims that are repeated so often that they become conventional wisdom, even if they have little or no grounding in actual fact.
Someone one who’s spent many years investigating these claims is Dr Lubos Pastor. He’s a Slovakian-American financial economist who is is the Charles P. McQuaid Professor of Finance at the University of Chicago Booth School of Business.
He’s a leading researcher on financial markets and asset management, and has published numerous award-winning papers, some of which featured here on The Evidence-Based Investor and which you’ll find in our Research section.
Lubos Pastor recently appeared as a guest of Jeff Ptak and Christine Benz on the Morningstar podcast, The Long View. It’s a fascinating interview, and in it he dispels six commonly shared investing myths.
Investing myth No. 1: Stocks become less volatile the longer the time horizon
What Lubos Pastor told The Long View:
“The conventional wisdom is that volatility of stock returns becomes smaller as the investment horizon increases. And my co-author and I — Rob Stambaugh and I — we find the opposite. We find that long-horizon investors actually face more volatility per period than short-horizon investors. And this is not because we argue that some people crunched their numbers incorrectly. Not at all. It’s because we compute volatility looking into the future rather than back in the past.
“Let me take a step back. This conventional wisdom that stocks are less volatile in the long run is based on historical estimates of volatility. So, you look back, you determine the average return. Suppose it’s, let’s say 10% per year nominal. And you compute volatility at various horizons around that known average return. Well, we look into the future, as we believe investors do, and we compute volatility around this unknown mean that we’re going to have going forward. We don’t know what the average return is going to be in the future. And this forward-looking variance that we calculate takes this uncertainty about the mean into account. And that is the main reason why we find stocks being more volatile in the long run rather than less volatile. So, it’s not that we find that there’s no predictability or no mean reversion in returns. We actually do find mean reversion in returns. It’s just that we find that mean version is more than offset by uncertainty about the trend around which stock prices are going to fluctuate in the future.”
Investing myth No. 2: Greener assets should produce higher returns in the long term
What Lubos Pastor says:
“My co-authors Rob Stambaugh, Luke Taylor, and I, we actually do find a clear link between greenness and expected returns. Specifically, we argue both theoretically and empirically that greener assets have lower expected returns. And we give two reasons. One is based on tastes, and one is based on risk. So, the taste reason is that people love holding green assets. Investors love holding them. So, in equilibrium, these greener assets end up with higher prices and therefore, lower expected returns going forward. And then, there’s a risk reason that also generates lower returns for greener assets, and that is that greener assets are a better hedge against climate risk. Or flipping this around, brown assets are more exposed to climate risk. So, they have to offer higher expected returns to compensate. So, again, both of these channels, economic channels, tastes and risk, leads to lower expected returns for greener assets.
“Why has ESG become so popular? … I’d say people love holding assets that they like even for non-pecuniary reasons. As our society grows richer, people are increasingly willing to pay more for organic coffee, pay more for clothes that are made by companies that they like, things like that. So, I think that’s why ESG has grown. I think people value non-pecuniary issues more and more.”
Investing myth No. 3: Actively managed equity funds perform well during periods of market turbulence
What Lubos Pastor says:
“(Blair Vorsatz and I) used Morningstar data to look at the performance of mutual funds, U.S. mutual funds, during the COVID crisis. We looked at the worst part of the COVID crisis, like the March and April of 2020. And what we found was that active funds underperformed passive benchmarks during this crisis and by a wide margin, something like three quarters of all funds underperformed the S&P 500 and almost 60% of them underperformed their corresponding FTSE Russell benchmarks. And this, at least to us, was somewhat surprising, because when people point to active fund’s underperformance, long-run underperformance, they often say, well, active funds underperform in the long run, but they make up for it because they perform better, they outperform in bad times, like in recessions or in crises precisely when you want them to outperform. So, this is commonly given as a justification for investing in active funds.
“So, we looked for it in the biggest economic crises that we’ve had in a long time, in the COVID crisis of 2020, and we didn’t find any support for that hypothesis. Instead of outperforming, active funds actually underperformed by a pretty wide margin.”
Investing myth No. 4: The more experienced a fund manager is, the better the performance
What Lubos Pastor says:
“This is a paper I did with Luke Taylor and Rob Stambaugh. What we find specifically is that fund performance tends to deteriorate over a fund’s lifetime. As a given fund grows older, its performance tends to get slightly worse, benchmark-adjusted performance. So, in that sense, newer funds perform better because you perform better when you’re younger than when you’re older. And this is controlling for lots of things.
“Why is that? Our story, the story we tell in our paper, is that it’s an issue of growing competition. So, suppose you just graduated from Chicago Booth with an MBA. You have all this cutting-edge knowledge about the best investment strategies, and so on. Couple of years later you start running a fund. You are on the cutting edge. You’re going to be doing really well. But then, as time passes, 10 years later, 15 years later, maybe your knowledge is not so cutting edge anymore. New graduates start running new funds, and perhaps, they’ll outperform you unless you keep up successfully. So, that’s our story, that there’s growing competition over a fund’s lifetime that tends to make their performance worse.”
Investing myth No. 5: The more funds there are, the better it is for investors
What Lubos Pastor says:
“There’s this question about whether scale of investment is somehow related to future returns, and there’s this notion of decreasing returns to scale in active management. Most of the time people talk about fund level decreasing returns to scale—the idea being that as the size of my fund increases, then my fund’s performance gets worse. The idea there is that if I manage a larger fund, then my transaction costs go up and that’s why I’m going to have to end up trading less and my performance will suffer as a result.
“My research with Rob Stambaugh and Luke Taylor on this topic talks more about the decreasing returns to scale at industry level. So, instead of fund level, we look at industry level. What we find is that as the size of the active management industry increases, then everybody’s performance declines. So, when there’s more money that’s actively managed, when more money chases mispricing, loosely speaking, then every active fund will find it more difficult to deliver alpha. Essentially, there’s more competition and that decreases everybody’s performance. So, that’s the gist of it. Instead of decreasing returns to scale at fund level, we emphasize decreasing returns to scale at industry level. And I actually believe that both of these channels are in play.”
Investing myth No. 6: Private equity funds, unlike stock funds, are not subject to short-term fluctuations in value
What Lubos Pastor says:
“I have heard the argument and I agree — if you look at private equity returns, they appear to be smooth, but they appear to be smoother than they really are, is my perspective on it. Private equity is just equity, just like public equity. And the only reason you don’t see it fluctuate as much as public equity is that you don’t have prices minute to minute, hour by hour. So, it is fluctuating more than its smooth returns, reported returns suggest.
“I personally am unwilling to pay a cent for this kind of smoothing. So, why should I pay anything at all for this type of smoothing? Perhaps there are some institutional investors out there who do appreciate this. But there’s a question of price. How much would you be willing to pay just to feel better. Because your reported volatility is lower than it really is. So, I wouldn’t pay much for it.
You can listen to the full interview with Lubos Pastor on The Long View here.
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