Prof. John Y. Campbell: Financial Decisions for Long-term Investors | Rational Reminder 250

Episode Overview

• Professor John Y. Campbell redefines risk for long-term investors, shifting the focus from short-term portfolio volatility to the stability of one's future standard of living (sustainable consumption).
• The discussion explores the intertemporal nature of asset pricing, distinguishing between "good" discount-rate risk (hedged by growth stocks) and "bad" cash-flow risk (prevalent in value stocks), which has significant implications for portfolio construction.
• Campbell applies theoretical finance to practical decisions, covering optimal foreign currency hedging strategies and identifying common, costly mistakes in household finance.
• The conversation covers foundational topics like utility theory and defines the true risk-free asset for a long-term investor as an inflation-indexed bond, challenging conventional wisdom about T-bills.

Key Concepts

• Long-Term Investor Risk: True risk is not the volatility of wealth but the volatility of the sustainable consumption (standard of living) that wealth can support over time.
• Reinvestment Risk: A fall in the long-term rate of return can be as damaging to a long-term investor's lifestyle as a significant loss of principal.
• Intertemporal Hedging: The strategy of holding assets whose values rise when future expected returns fall, thereby stabilizing long-term consumption. Stocks and long-term bonds can serve this function due to mean reversion.
• "Good Beta" vs. "Bad Beta": Risk is decomposed into two types. "Bad beta" is exposure to permanent cash-flow shocks (common in value stocks), while "good beta" is exposure to temporary discount-rate shocks (common in growth stocks).
• Value vs. Growth Stocks: Value stocks offer a premium for bearing "bad" cash-flow risk. Growth stocks, with their long duration, act as a hedge against changes in discount rates and increases in market volatility.
• Stochastic Volatility: The concept that the market's overall risk level is not constant but changes randomly over time. Rising volatility is bad news for investors as it worsens the risk-return tradeoff.
• Human Capital: A young person's future earning potential acts as a large, stable, bond-like asset that justifies holding a higher allocation to equities in their financial portfolio.
• The True Risk-Free Asset: For a long-term investor planning to live off their assets, the risk-free benchmark is a long-term, inflation-indexed bond or annuity, not a short-term Treasury bill.
• Currency Hedging: For equities, "safe haven" currencies (USD, JPY, EUR) can hedge stock market risk. For fixed income, currency exposure is "pure noise" and should be fully hedged.
• Household Finance Challenges: Individuals face complex financial problems, often making costly mistakes like failing to get employer retirement matches, poor diversification, and improperly insuring against catastrophic risks.

Quotes

• At 0:31 - "'Some of those interviews are so good, I have to listen to them two and three times'... Well, this is at least a two-time listen. This was a phenomenal conversation with Professor John Y. Campbell." - Cameron Passmore sets the stage for the interview's depth, based on listener feedback.
• At 1:58 - "We talked about utility theory, which, as important as it is to the study of finance... it's not something that we've gone through with ourselves or with any other guest, but he's arguably the best person to do it." - Ben Felix highlights a foundational topic of the discussion.
• At 25:46 - "For a long-term investor, risk is not the volatility of wealth over a single period... It's the volatility of the consumption that can be supported by that wealth, the standard of living that you're able to support." - Campbell redefines risk for long-term investors, shifting the focus from portfolio value fluctuations to the stability of their future lifestyle.
• At 26:33 - "That's just as bad for a long-term investor as losing half your wealth." - Campbell explains that a 50% drop in the long-term real interest rate is as detrimental to a long-term investor's sustainable consumption as a 50% loss in their portfolio's principal value.
• At 28:06 - "Stocks are risky long-term assets, but they also have this property because there's evidence that the expected future real return on stocks declines when the level of the stock market goes up." - He explains that stocks, like long-term bonds, can act as a hedge for long-term investors because their expected returns are mean-reverting.
• At 30:29 - "Invest over one year, you know, annualized risk, say 16%. Invest over 30 years, more like 8%." - Campbell provides a quantitative example of how mean reversion in stock returns significantly reduces their annualized risk over longer investment horizons.
• At 34:27 - "The risk-free asset for a long-term investor is a long-term inflation-indexed bond... a bond is going to pay you a fixed real coupon... and that is known in advance." - He defines the true risk-free asset for someone planning to live off their investments.
• At 43:12 - "A young investor with many years of future earning power has an implicit asset that is relatively safe. This is what... economists call human capital... your human capital is orders of magnitude larger probably than your financial assets." - Campbell explains that a young person's future earnings act like a large, stable, bond-like asset.
• At 49:20 - "We say you've got good cholesterol and bad cholesterol... We say you've got good beta and bad beta. And the bad beta is high for value stocks, even though the total beta is low." - Using an analogy, he explains that value stocks' higher returns are compensation for their exposure to "bad" cash-flow risk.
• At 51:25 - "The conservative long-term investor should be reluctant to take a value tilt... despite the fact that there's this value premium, because value stocks increase their long-run risk." - Campbell provides a surprising portfolio implication for risk-averse long-term investors.
• At 58:21 - "'When risk goes up, that's bad news for investors because... for any given amount of return that you're getting in the stock market... if the risk is high, then you're having to take more risk to get the same return.'" - Campbell explains the negative impact of rising market volatility on an investor's risk-return trade-off.
• At 59:55 - "'For long-term investors, growth stocks are a hedge because they hedge against increases in risk. And so that effect can further help the intertemporal model explain why value stocks have higher average returns.'" - He connects the hedging properties of growth stocks to the theoretical explanation for the value premium.
• At 1:01:52 - "'There's other currencies like the Euro, the Yen, and the US dollar that tend to move the other way... These currencies that... move against the stock market are particularly attractive for long-term investors because they hedge the... equity exposure in a relatively cheap way.'" - Campbell identifies which major currencies act as a "safe haven" or hedge against stock market downturns.
• At 1:05:07 - "'The... easiest mistakes to sort of prove unambiguously are the cases where people leave money on the table. They... for example, failing to exploit an employer match for a retirement fund.'" - He provides a clear example of a common and undeniably costly financial mistake.
• At 1:06:51 - "'Ironically, a household's financial problem is actually much more complicated and harder to... solve... than a corporation's problem, even though the corporation is much more sophisticated.'" - Campbell highlights the underappreciated complexity that individuals face when managing their personal finances.
• At 1:14:22 - "'The deepest joy in life is about sharing life with a partner you love and trust, and helping younger people grow up to be happy and productive adults.'" - Campbell defines success not by external validation but by the pursuit of knowledge and the richness of personal relationships.

Takeaways

• Redefine your personal measure of risk from short-term portfolio volatility to the long-term stability of the lifestyle your assets can support.
• Young investors should treat their future earnings (human capital) as a large bond holding, justifying a higher allocation to equities in their financial portfolio.
• For a true "safe" asset that provides a predictable living standard in retirement, use long-term inflation-indexed bonds as your benchmark, not T-bills.
• Conservative long-term investors should be cautious with a strong value tilt, as value stocks carry "bad" cash-flow risk that can permanently impair long-term consumption.
• Utilize "safe haven" currencies like the US dollar, Yen, and Euro to hedge against downturns in a global equity portfolio.
• Always fully hedge the currency exposure in your international bond portfolio, as it adds uncompensated volatility.
• Prioritize avoiding major financial blunders like missing an employer 401(k) match or failing to insure against catastrophic risks like disability.
• Appreciate that personal finance is uniquely complex and consider using simplified products or technology like robo-advisors to manage it effectively.
• For long-term success, favor assets like stocks and long-term bonds that can hedge against falling future interest rates, thereby stabilizing your financial future.