"Portfolios for long-term investors" is published, Review of Finance 26(1), 1-42. (2022). This standard link works if you have institutional or individual access. I am not allowed to post a free access link here, but I am allowed to post one on my webpage where you will find it.
The theme: How do we account for the vast gulf between portfolio practice and portfolio theory? How do we make portfolio theory useful given that the world has time-varying expected returns and time-varying returns and correlations? I argue for a view more focuses on prices and payouts, as a long-term bond investor should buy an indexed perpetuity and ignore one-period returns. I advise one to think about the market and equilibrium. The average investor must hold the market portfolio. Anything else is a zero sum game. So figure out why you are different than average. (If you think you're smarter than average, note that they think they're smarter than you.) The result encapsulates some ancient advice: Buy stocks for the dividends, broadly interpreted. Take risk you are well-positioned to take. If stocks have great value to other investors for reasons either technical (liquidity, short-sales constraints, etc.) or behavioral, avoid them.
The paper grows out of the summary I used to give for MBA and PhD students. There aren't any equations, but there are lots of suggestions about how academic portfolio theory might be done better, and connect better to its intended audience. Thanks especially to Monika Piazzesi and Luis Viceira, who invited me to give the talk on which it is based, and Alex Edmans who shepherded it to publication.
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Update: I just found that the NBER has posted the original lecture video
This is an important paper for RIA's looking to better justify their fees. So important, in fact, that I wrote a distilled version of the original keynote speech for RIAs (no, few read long papers or listen to long presentations): https://alphaarchitect.com/2021/07/08/leading-emh-economist-john-cochrane-advocates-for-advisor-fees/
ReplyDeleteSadly, the dynamics of the industry favor those with asset gathering skills rather than the ability to help smooth consumption. Most individual investors want to pay alms to their false prophets and in return be told how safe they are before they doze off to sleep. Those few willing to read and capable to understand John's blasphemy don't bother hiring advisors. Especially now that the Dimensional Fund Advisors' barn gates are open.
Still, I'm glad John is trying and happy to lend a hand.
I should note, John certainly doesn't imply "fees are justified" and I admit as much (I had hoped) by calling my title click bait in the opening sentence. Very few advisors follow his advice and thus justify their fees.
DeleteFor the average individual, the following are likely to be the largest purchases over a lifetime:
ReplyDelete1. Primary residence
2. Transporatation (personal vehicles)
3. Energy
4. Higher education
5. Medical care
Do any of these fall into the "long term asset portfolio" for investors?
If you don't confine your assets to "financial assets" that have some promise to pay cash flows (and I think John does), you end of investing in NFTs and Crypto (or maybe Jackson Pollock paintings...not saying you can't eventually sell anything higher in the future). Plus, these non-financial assets on your list cover a liability (a place to live, need to get somewhere, live comfortably, converse intelligently, and avoid sickness) so can live outside of your portfolio.
DeleteNot that you were really serious, but as John points out, all these assets are dwarfed by your own human capital (i.e., your ability to make your own cash flow). That asset is what needs the most tending to and arguably while value stocks that do poorly in a recession offer a risk premium.
John,
ReplyDelete"The paper grows out of the summary I used to give for MBA and PhD students."
Do you tell those students they are wasting their (or their parents) money pursuing a higher education (MBA or PhD degree) and should instead be plowing that money into the stock / bond markets?
"Buy stocks for the dividends". What? Stock returns come from value appreciation, not dividends. If you own a $100 share of stock, and then there's a $5 dividend, then you own a $95 share of stock and $5 cash.
ReplyDeleteThis is a common and important fallacy. Short-run stock returns do come from value appreciation (or depreciation!) But the title is "for the long-run investor." Value appreciation can only go so far. The price/earnings, or price/dividend ratio can only grow so far. Eventually, when price/earnings or price/dividend ratios run out of steam, the long-run return is completely dominated by the growth in dividends (including all cash payouts to investors.)
DeleteThanks for the response, but I disagree. I feel like you're neglecting share buybacks. Also, there's nothing stopping a company growing for hundreds of years, making profits and reinvesting them (or share buybacks if there are not growth opportunities).
DeleteAnd again, dividends only come from value appreciation. A company can't give a $5 dividend unless they actually appreciated in value the $5 first. Dividends are merely a mechanism for transferring cash from the company to shareholders and dividends are not the only such mechanism.
Jacob, you are correct there is nothing stopping a company growing for hundreds of years and reinvesting all its profits and/or buying its shares back. And yes, buybacks are equivalent to dividends in terms of transferring cash to shareholders (and arguably, much more tax efficient).
DeleteBut John's point is that even then, after hundreds of years, there is a limit to growth and a finite number of shares to buy back. Perhap in this future world, this fantasy company has swallowed up all other companies and all but one of its shareholders. Even then, that single remaining shareholder would demand some reward for sticking around.
1) If a company grows at the same rate (or less) as the economy/whatever, then the company has not "swallowed up all other companies" even after arbitrary time has passed.
Delete2) There are a finite and unbounded number of shares that can exist. Imagine that every time the share price reaches $100, there is a 2-for-1 split. Running out of shares for share buybacks is not an issue.
Perhaps you should first imagine a simpler scenario where a company provides long-term value without ever paying a dividend AND NO GROWTH. Imagine a company that every year makes exactly $50K in profit and spends that $50K on share buybacks. Every time the share price reaches $100, there's a 2-for-1 split. This goes on for as long as you wish. There you go; a very modest company providing long term value for investors without a single dividend and no growth.
You can add growth to the picture. Every year the economy grows as 2% and the company's profits grow at 1% (this goes on for quite some time until we saturate the observable universe with the most economically efficient arrangement of matter and energy). The company reinvests some of its profits and spends the rest on share buybacks. Shares are splits as needed. Over time the company is a smaller proportion of the overall economy despite growing every year.
sory, correction to my first reply. I did say a "finite number of shares..." at first. That was wrong. I should have said "finite number of shareholders..."
DeleteWhy would number of shareholders dwindle over time? That is not necessarily so.
DeleteEven if there is only one remaining shareholder, that is no obstacle to share buybacks allowing the company to deliver cash flows to that single shareholder.
Your objections are very puzzling to me.
I think we both agree that everything else being equal, over any discrete time period, shareholders are indifferent if the company pays dividends, buys back stock, reinvests in more factories or stock piles cash. It's pure Modigliani-Miller. But....
ReplyDelete1) Who do you expect to eventually buy the company that is growing (or not) to become a trivial part of the economy with no promise of a payout? Not that the "great fool theory" isn't alive and well in NFT and Crypto space, but stops any interesting discussion of finance.
2) I said shareholders, not shares. Eventually, the sold remaining shareholder needs to find a "rational" (see note 1) counterparty whether they own 1 share or a million.
I do agree it helps to create real but simplified worlds (aka models) to help explain our much messier reality. In fact, I did so a few years ago in this article on buybacks: https://alphaarchitect.com/2018/08/30/buybacks-why-they-dont-matter-why-they-do-and-why-you-should-care-yet-still-relax/
No promise of a payout? There are share buybacks. The company is willing to offer cash for your shares. No fool of any type is needed to turn your shares into cash flows.
DeleteJon Seed, I don't know you very well, but you seem to have a very strange quirk of treating share buybacks very differently than dividends. Why is it that you gave dividends a free pass to all your concerns but are so skeptical of share buybacks? Dividends and share buybacks are both mechanisms for a company to deliver cash to shareholders (aka give a "payout" as you are concerned about).
I will agree, a firm can always buy everyone out and take the company private. A buyout is a "payout" my last remaining shareholder will rationally accept.
DeleteJon, I didn't say anything about buying everyone out (completely) and going private. I talked about normal share buybacks where <100% of outstanding shares are bought by the company, specifically about the situation of one shareholder that you seem concerned about. Share buybacks can go on for arbitrarily long amounts of time without completely buying everyone out and going private.
DeleteI know. I just think we exhausted this conversation. For the record, though, I agree in the equivalence of buyback and dividends (I linked to my article earlier) and I'm sure John is as well. I also agree then can go on for "arbitrarily long amounts of time".
DeleteI disagree that buybacks can go on forever. I tried to use the natural end point (one last remaining shareholder) to illustrate why a firm has to eventually make a "payout", but obviously I failed.
We can try one last time: why do you think that the situation of one shareholder and share buybacks can't go on forever? A sole shareholder can receive cash flows from the company via share buybacks forever (much like dividends).
DeleteIt seems your mom has a hunch about non ergodicity.
ReplyDelete