RR # 169 - John Cochrane: (Modern) Modern Portfolio Theory

Episode Overview

• The podcast explores why stock market valuations fluctuate, explaining that it's driven by changes in expected future returns (discount rates) rather than changes in expected future cash flows.
• It reframes the concept of investment risk for long-term investors, arguing that time horizon is a critical factor and that short-term price volatility is often temporary.
• The discussion provides a framework for personal portfolio construction, emphasizing the need to hedge individual risks (like one's career) rather than simply trying to beat the market.
• The conversation touches on the future of finance, expressing skepticism about Bitcoin's long-term value while highlighting the transformative potential of its underlying technology for the financial system.

Key Concepts

• Stock market volatility is primarily driven by changes in discount rates (expected future returns), not by changes in expectations about future cash flows like dividends or earnings.
• This "return predictability" is consistent with an efficient market where risk premiums rationally change over time, being higher in bad economic times and lower in good times.
• Predictability introduces "horizon effects," meaning an asset's riskiness depends on the investor's time horizon; over long periods, stocks behave somewhat like bonds, with lower prices implying higher future returns.
• Long-term investors should adopt a "payoff perspective," focusing on the future stream of cash flows their portfolio will generate rather than on short-term, mark-to-market price changes.
• The true "risk-free" asset is relative to an investor's goals; a 30-year inflation-indexed bond is risk-free for a 30-year goal, despite its price volatility.
• Portfolio construction should be used to hedge an individual's unique risks, particularly their human capital and career, which is a valuable, non-zero-sum activity.
• Trying to beat the market (seeking alpha) is a zero-sum game, but deviating from the market to hedge personal risk provides immense utility.
• It is critical to avoid concentrating risk by investing in one's own company or industry, as this links financial capital directly to human capital.

Quotes

• At 3:51 - "For the market as a whole, the answer is pretty much no. That higher prices relative to current earnings correspond to lower returns in the future." - Cochrane explains that for the overall market, high valuations predict low future returns, not high future cash flow growth.
• At 25:47 - "Stocks are a bit like bonds." - This is the central analogy used to explain that a lower stock price today implies higher expected returns in the future, just as a lower bond price means a higher yield.
• At 26:04 - "Predictability tells you that people with longer horizons can afford to take that risk better than people with shorter horizons." - This is the key practical implication of horizon effects; time horizon dictates risk capacity for temporary price fluctuations.
• At 56:23 - "Don't invest in your own company. Don't invest in your own industry." - Cochrane gives this as one of the most important pieces of advice for managing personal risk.
• At 58:08 - "Deviating from the market portfolio is a zero-sum game... from a financial perspective." - He explains that while seeking alpha is a zero-sum activity, deviating from the market to hedge personal risks can be a highly beneficial, non-zero-sum activity for an individual.

Takeaways

• Reframe market volatility: View low stock prices not just as a loss, but as an indicator of higher future expected returns, which is a rational reflection of higher risk in bad economic times.
• Leverage your time horizon to manage risk: For long-term goals, the primary risk is a permanent loss of future cash flows, not temporary price drops that can be "waited out."
• Invest to hedge your life, not just to beat the market: The most valuable portfolio decisions are those that diversify the unique risks associated with your career and human capital.