Charles W. Hodges

Time Diversification and Security Preferences: A Stochastic Dominance Analysis

We use stochastic dominance to test whether investor should prefer riskier securities as the investment horizon lengthens. Return distributions for stocks, bonds, and U.S. Treasury bills are generated for holding periods of one to 25 years by simulation. For each holding period, stochastic dominance tests are run to establish preferences between the alternative security classes. Contrary to previous mean-variance based studies, we find no evidence that high-risk securities (stocks) dominate low-risk securities (bonds, Treasury bills) as the investment horizon lengthens. However, we do find that corporate bonds systematically dominate government bonds.

The Sharpe Ratio and Long-Run Investment Decisions

We investigate the empirical relationship between the Sharpe ratio and the investment horizon for portfolios of small stocks, large stocks, and corporate bonds. Sharpe ratios are calculated for holding periods of one through 25 years using returns generated by a simulation procedure that preserves serial correlation present in actual returns. We show that relative portfolio rankings vary with the investment horizon and portfolio rankings for autocorrelated returns are different from those for independent returns. Our results indicate that Sharpe ratios computed by investment advisory services such as Morningstar Mutual Funds that are based on short-term return intervals must be interpreted with care by long-term investors.

Beta, the Treynor ratio, and long-run investment horizons

Beta and Treynor ratios are computed for portfolios of small stocks, large stocks, and bonds for holding periods of 1 to 30 years. For both the stock and bond portfolios, beta, and the Treynor ratio change substantially with the holding period. Furthermore, the relative Treynor rankings of the portfolios change. Therefore, betas and Treynor ratios cannot be calculated independently of the intended investment horizon. Investors with long-run investment horizons must interpret performance parameters obtained from investment advisory services with due consideration for horizon effects.

Product market competition, corporate governance, and cost of capital

We investigate how market competition and corporate governance affect a firm’s cost of equity and debt. We find firms with better corporate governance have a lower cost of equity and cost of debt. However, we find that the negative relation between cost of capital and governance primarily holds for firms in highly competitive industries. The relation between governance and cost of capital does not hold if the industry competition is weak.

TIME DIVERSIFICATION AND STOCHASTIC DOMINANCE

We use stochastic dominance to test whether investors should prefer riskier securities as the investment horizon lengthens. Simulated return distributions for stocks, bonds, and U.S. Treasury bills are generated for holding periods of one to 20 years and stochastic dominance tests are run to establish preferences among the alternative portfolios. With independent returns, we find no evidence that high-risk securities (stocks) dominate low-risk securities (bonds) as the investment horizon lengthens. Under the assumption that security returns are correlated across time, we find that common stocks dominate corporate bonds and U.S. Treasury bills for sufficiently long investment horizons.

Swiss Security Return Performance and the Investment Horizon

Investors often hold foreign securities in order to diversify their portfolios. This raises the issue of whether there are unique risks associated with long-term investments in non-domestic securities. The authors investigate the empirical relationship between the Sharpe ratio and the investment horizon for portfolios of Swiss stocks and bonds and then compare these results to U.S. stock and bond portfolios. Sharpe ratios are calculated for holding periods of one to 25 years under the contrasting assumptions that returns are independent or auto-correlated. The results for Swiss securities are very similar to those for U.S. securities. Under independent returns, bonds outperform stocks for longer time horizons, while for auto-correlated returns, equities outperform bonds for all holding periods.