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Style boxes and other constructs of the investment industry are meaningless when it comes to portfolio theory, according to financial economist John Cochrane of The Hoover Institution at Stanford University. Instead, investors should focus on cash flows and market equilibrium.
Cochrane recently posted a paper on long-term investing. It is grounded in the latest academic research on asset pricing and portfolio theory but challenges the conventional approach to portfolio management. In the process, it highlights several areas where advisors can add value to client relationships.
Cochrane’s thesis is that academics and practitioners have parted ways since Harry Markowitz ushered in modern portfolio theory. Many later academic advances have not been widely adopted in practice, even by sophisticated investors. Instead, the investment industry has created “style boxes” and monikers such as “growth and income,” “core,” “dividend appreciation,” and many others. Cochrane asks, “What do all these names mean? The style names are mostly meaningless to me, a finance professor.”
He proposes two perspectives to help reunite theory and practice: 1) a focus on payoff streams over time; and 2) a focus on general equilibrium. I’ll briefly describe each.
Payoffs streams
Cochrane wants long-term investors to focus on payoff streams rather than average periodic returns. In this framework, the risk-free return is not a series of Treasury bill yields but an inflation-indexed perpetuity. While the present value of a perpetuity fluctuates significantly as interest rates change, the cash flows relative to inflation do not. Long-term investors should ignore price changes due to interest rates.
Focusing on payoffs is intuitive for long-term bonds. Bonds are after all promises of a series of cash flows. Prices fluctuate with rates, but the cash flows stay intact.
Cochrane proposes extending the payoff stream perspective to stocks. In this view, stocks are claims against an (uncertain) stream of future dividends. This includes both actual dividends and “synthetic dividends” created through incremental portfolio liquidations and share repurchases.
General equilibrium
The general equilibrium perspective is summed up in the following theorem: The average investor must hold the market portfolio. The market portfolio should be the starting point for any long-term investor. Any deviation from the average needs to be justified by differences in investors, i.e., investor heterogeneity. Deviations are zero-sum: A departure from the market portfolio must have an equal and opposite departure elsewhere. For every buyer there must be a seller.
Thus, to the extent investors (or their advisors) want to depart from equilibrium, they must have a clear picture of how they are different from the average. Cochrane references a large academic literature on investor heterogeneity. Among the ways in which investors differ are their human capital, risk aversion, time horizon, exposure to uninsurable risks, liquidity needs, and differing beliefs.
Equilibrium also requires a well-formed view of “who is on the other side.” For example, an advisor who recommends a client go long value should have a clear view on which investors have reason to be short value.
Implications
What are the implications of adopting these perspectives?
The strong return of long-term bonds over the past several decades cannot be “banked” by assuming a historical average return in the future. A run-up in bond prices does not alter the expected payoff stream. (This ignores taxes – I discuss the potential tax benefit here.) Nor are long-term investors necessarily hurt if their bond portfolios decline when rates rise.
Similarly, for stocks, it behooves investors to focus on the underlying dividend/cash flow stream. The sensitivity of valuations to discount rates (“discount rate beta”) does not increase consumable cash flows in the future. Investors should focus instead on “cash flow betas”: price changes due to changes in long-run dividends. Of course, estimating long-run cashflows is not easy. As Cochrane quips, “You can have a great stream for a while if you plunder the terminal value.”
The payoff perspective highlights that small differences in yield – e.g., advisory fees, liquidity premia, credit spreads – translate into large differences in payoff streams. The current AAA corporate bond yield is 1.77%. This represents a 51-basis point spread over Treasury yields. But in terms of payoff, the corporate bond pays 40% more than the Treasury.i
There are implications for retirement income planning. As Cochrane points out, we cannot take a portfolio with 20% volatility and expect it to reliably fund a consumption stream with 1% volatility. By focusing on payoff streams, and adjusting consumption for the riskiness of those streams, we are more likely to end up with a successful plan.
The general equilibrium perspective can help anchor assessments of risk tolerance: As a first approximation, it can usefully be boiled down to, “is this investor more or less risk averse than average.”
The general equilibrium and payoff perspectives also help when thinking about rare disasters. These are situations when normal statistical relationships and portfolio models break down. One way to prepare is with explicit stress tests, not unlike what the Fed does for banks.
This is not a comprehensive list. Using the lens of payoffs and equilibrium will reveal other areas for exploration.
The role of advisors
By adopting the payoff and equilibrium perspectives, Cochrane sees opportunities for advisors to add value and get paid for it. Some examples:
- Help clients understand how they are different from average and adjust portfolios for the streams that give rise to that heterogeneity. A simple example would be to exclude industries in which clients earn labor income from their portfolios. (This would be a good application for direct-indexing solutions.)
- Rigorously and comprehensively quantify consumption needs. Portfolio streams must be evaluated against consumption streams. Cochrane discusses this in the context of university endowments. For example, tenured faculty salaries are a fixed consumption item for universities – few endowments explicitly take this into account.
- Explicitly identify risk buffers in consumption. For example, clients might view bequest objectives in retirement plans as available to absorb adverse outcomes.
- In heterogeneity, Cochrane even sees some opportunities for active management. For example, he suggests that the academic literature on cashflow betas supports a value tilt for short horizons and a growth tilt for long horizons.
Conclusion
As I interpret Cochrane, academics and practitioners share responsibility for the dissonance between theory and practice. Investors lose out because they don’t benefit from the advances in academic findings, and academics are unmoored from reality in their research. Cochrane’s reframing is an attempt to reunite the two sides. Comprehensive financial planning is well positioned to stand in the middle.
Peter Hofmann, CFA, is with Fieldmark Advisors, a registered investment advisor based in North Salem, N.Y.
iSource: Data Indices, LLC, ICE BofA AAA US Corporate Index Effective Yield [BAMLC0A1CAAAEY], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLC0A1CAAAEY, August 6, 2021
