Working Paper: NBER ID: w14757
Authors: Lubos Pastor; Robert F. Stambaugh
Abstract: According to conventional wisdom, annualized volatility of stock returns is lower when computed over long horizons than over short horizons, due to mean reversion induced by return predictability. In contrast, we find that stocks are substantially more volatile over long horizons from an investor's perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return. Mean reversion contributes strongly to reducing long-horizon variance, but it is more than offset by various uncertainties faced by the investor, especially uncertainty about the expected return. The same uncertainties also make target-date funds undesirable to a class of investors who would otherwise find them appealing.
Keywords: Volatility; Long Horizons; Predictive Variance; Parameter Uncertainty; Target-Date Funds
JEL Codes: G11; G12; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Mean reversion (C29) | long-horizon variance (C58) |
| Uncertainty about expected returns (D81) | long-horizon variance (C58) |
| Estimation risk (C13) | long-horizon variance (C58) |
| Parameter uncertainty (C51) | long-horizon variance (C58) |
| Predictive variance at 50-year horizon (D15) | predictive variance at 1-year horizon (C29) |
| Mean reversion + uncertainties about expected returns (D84) | long-horizon predictive variance (C58) |
| Parameter uncertainty + imperfect predictors (C51) | predictive variance (C29) |
| Long horizons (D15) | perceived volatility (G17) |
| Target-date funds with known parameters (G23) | investor preference (G11) |