The Risks of Equities at Different Time Horizons

Abstract

It follows from the negative serial correlation of equity returns that they must have been mean reverting around a stable long-term average, the best estimate for which is 6.7 per cent. This is a relatively recent development in financial economics, which must be incorporated into macroeconomic models if they are to include finance. Equities have no maturity, and their returns are volatile over all time periods though the volatility declines the longer the investors expect to hold them. Although the composition of the stock market changes as companies are liquidated and new ones take their place, in aggregate equities are irredeemable. To be compensated for the risk that this involves, investors need a higher return and its extent depends on their aversion to risk. If the risk aversion of investors has been historically constant, the required return on equities for different time horizons will have been also because the volatility of equities has been mean reverting. Although their distribution is not quite normal it has been approximated closely enough for the probabilities of returns to be calculated as if it were. We can therefore measure the risks of holding equities over different time horizons.