Wishful Thinking About the Risk of Stocks in the Long Run: Consequences for Defined Contribution and Defined Benefit Retirement Plans

Abstract

It is widely believed that although stocks are very risky in the short run, in the long run they are far less risky and are sure to outperform risk-free investments such as government bonds. This belief is a dangerous fallacy. It leads to the illusion that one can earn an equity risk premium without bearing risk. In this paper, I first explain the flawed reasoning behind the fallacy: the appeal of the misleading concept of time diversification. Then I discuss the probability that an equity shortfall is indeed a decreasing function of the length of the investor’s holding period T. But the severity of a possible shortfall, and therefore the cost of insuring against it, is an increasing function of T.

Finally, I explore some of the fallacy’s harmful consequences with respect to (1) the regulations governing employer-sponsored retirement plans, such as 401(k) plans, that automatically enroll participants into qualified default investment alternatives (QDIAs) such as a life-cycle or targeted-retirement-date fund, a balanced fund, or a professionally managed account, and (2) the measurement and funding of state and local government pension promises, and I recommend measures to counteract them. These include (1) adding a new QDIA option in employer-sponsored retirement plans that automatically enroll plan participants in QDIAs and (2) the Government Accounting Standards Board (GASB) adopting new rules for measuring and reporting the liabilities of state and local government pension plans.

Keywords: equity risk premium, diversification, time diversification, stock risk

JEL Classification: G10, G11