Requisites for Long-term Growth in Financial Markets

Andrs Urbn urban@nance.bme.hu Department of Finance Budapest University of Technology and Economics, Muegyetem rkp. 9, Building R, Budapest, Hungary, H-1111 October 16, 2011

In the paper multi-period investments are investigated where the initial capital and its gains are reinvested after each trading period. It is pointed out that the advantage of holding investments with high return expectations is not a general truth, even in the long-run, since if the investment is very risky the investor cannot rely on positive growth of capital. The paper presents the optimal trade-o between the single period mean and variance which provides maximum growth if the return distribution is not highly skewed and higher moments are negligible.
1 Introduction

Abstract

This paper gives an overview of multi-period investments. A multi-period investment is a consecutive sequence of single-period decisions where the initial capital and its gains are reinvested. I show, although maximization of the mean return is equivalent to the maximization of the expected wealth, an investor is able to near the expected wealth with a probability close to zero. Therefore the mean of the single period returns is not able to capture the growth of capital. It is pointed out that the advantage of holding investments with high return expectations is not a general truth, even in the long-run, since if the investment is very risky the feasible wealth level is notably lower than its expected value. The paper presents a close theoretical correspondence between the long-term growth and the classical mean-variance approach, where I use the variance as the only measurement of the investment risk. Furthermore, I show an optimal trade-o between the single period mean and variance which provides maximum growth if the return distribution is not highly skewed and higher moments are negligible.
2 Rate of growth

Investigating a market of long-term investments where capital gains are reinvested after each trading period. Evolution of the multi-period investment is easier to characterize using price relatives rather than rates of return. Price relative xi is a stochastic variable representing the relative change in the value of an individual asset or portfolio on trading period i such that
xi

pi , pi1

where prices on day i and i 1 are denoted by pi and pi1 , respectively. The relative price corresponds to rate of return since xi ri + 1, 1

where ri denotes the rate of return from trading period i 1 to period i. When price relatives are independent and identically distributed we can take the following expectation of the wealth Wn after n investment periods:
n

E{Wn } = E {W0 x1 x2 ... xn } = W0

i=1

E{x1 } = W0 en ln E{x1 } ,

(2.1)

where W0 is the initial wealth. Considering (2.1) an investor may guess that an asset promising maximum expected return will also gain the maximum wealth after several investment periods, where, under expected value I mean statistical expectation. Moreover, since on i.i.d. markets where the expected return and the variance exists
1 n
n
xi

E{x1 } as n

i=1 n
xi

and
Var 1 n

0 as n ,

i=1

an investor who has the opportunity to fund his wealth several times, has better a chance to reach his expectation on average than one who simply invests for a single period. This interpretation of the law of large numbers may suggest that if the investment horizon is very long, the investor should take only the expected return into account since the variance of the average relative converges to zero. We may accept this approach if we assume traditional conditions when the investor's utility function is based only on the mean and variance of the price relatives. This simple logic could lead to the argument that in the long-run it is worth holding investments with high return expectations, even if they are risky, since the risk disperses over multiple periods. Note, however, the variance of the average relative decreases as the length of the investment horizon grows, while the variance of the expected wealth does not. In lieu of the common mean-variance approach, I capture the nature of the capital growth by another way. One which characterizes how multiple-period growth works. In a multi-period investment Wn is the product of the former wealth Wn1 and the actual price relative such as
Wn = xn Wn1 ,

recursively

Wn = xn xn1 ... x1 W0 .
n

With more manipulation we can write

Wn = W0
i=1
xi

= W0 e

n i=1 ln

xi = W enGn , 0

(2.2)

where Gn denotes the average rate of growth

Gn = 1 n
n

ln xi .
i=1

Taking the logarithm in (2.2) gives ln

Wn W0

1/n

= Gn ,

which means that maximization of Wn and maximization of Gn are equivalent. Additionally, if xi relatives are i.i.d., ln xi log returns are i.i.d. too. Thus, the law of large numbers comes into play again with the following form: Gn E{ln x1 } as n , (2.3) 2

where E{ln x1 } is called expected rate of growth or simply expected log return. If n is large enough, the average rate of growth captures the typical value of Wn since
Wn W0 enE{ln x1 }

by (2.2) and (2.3). In the sequel without loss of generality I assume W0 = 1. The key to the novel approach lies in the recognition that Wn is not close to its mean E{Wn } if an investor funds his wealth several times. Continuing with this approach ,if n is large Gn is approximately normally distributed which implies that the event n
1 3 n{ln x1 } + E{ln x1 } < Gn = n < 3 n{ln x1 } + E{ln x1 }
i=1

has probability close to 1, where {ln x1 }

P = =

Var{ln x1 }. Furthermore, the i.i.d. property implies that

n i=1

P e

3 { x1 } + E{ x1 } < 1 n n 3 n{ln x1 }+nE{ln x1 } n{ln x1 }+nE{ln x1 }

ln

ln

ln xi <

<e

n i=1 ln

xi < e

3 { x1 } + E{ x1 } n 3 n{ln x1 }+nE{ln x1 } n{ln x1 }+nE{ln x1 }

ln

ln

P e3

< Wn = enGn < e3

therefore

Wn is in the feasible radius of enE{ln x1 } not of en ln E{x1 } ,

mean approach for capturing the long-term growth. Figure 1 contrasts the runs of the en E{x1 } expected wealth and the enE{ x1 } feasible wealth process on logarithmic scale, while the n number of periods grows. The solid black slope is the logarithm of the wealth expectation, the dashed black slope is the logarithm of the feasible wealth. The dashed grey curves assign the 3 n{ln x1 } condence interval around the logarithm of the feasible wealth. The evolution of the two sequences can be nicely distinguished, furthermore, if the sequences exceed n0 periods P {Wn0 < E{Wn0 }} > 0.99.
ln ln

E{ln x1 }. It is pointed out here, however, Wn has mean en ln E{x1 } , the wealth process takes values close or above its mean with a probability close to zero. For large n-s Wn absolutely diverges away from its mean, but the dierence also exists for lower ns too. This result casts a serious doubt on the application of the

where by Jensen inequality

ln E{x1 }

Hence, the principle raises that the concept that maximizing E{x1 } is not equivalent to maximizing the wealth in long-term and the average wealth multiplier is rather eE{ x1 } than e E{x1 } for a single period.
ln ln

Requisites for long-term growth

If an investor would like to achieve positive growth he should posses investments with E{ln x1 } higher than zero. Since the typical price relatives are around 1 Gyr, Urbn and Vajda [] suggested an approximation of the function ln z such as ln z z 1 (z 1)2 ,
1 2

Figure 1:

Runs of the expected and the feasible wealth.

which is the second order Taylor expansion at z = 1. In order to compute E{ln x1 } I use the approximation
1 E{ln x1 } E {x1 1} E (x1 1)2 . 2

(3.1)

Using identity

Var{z} = E{z2 } E2 {z} 3 1 2E {x1 } E x2 1 2 2 1 3 1 E2 {x1 } + 2E {x1 } E x2 E2 {x1 } 1 2 2 2 1 3 1 + Var {x1 } E2 {x1 } + 2E {x1 } 2 2 2 0.

we obtain the implicit condition on the single-period mean and variance for positive growth
E{ln x1 } = = >

(3.2)

Since larger expected relatives, ceteris paribus, imply larger growth rate, E{ln x1 } is an increasing function of E {x1 }. For (3.2) this condition is valid only when 0 < E {x1 } < 1, thus, the lower square root of the inequality will be relevant, the other one is false. Hence, in order to achieve positive growth we have the condition (3.3) E{x1 } > 2 1 Var {x1 } subject to 2 > E{x1 } and 1 > Var {x1 } , which conditions are necessary for the validity of the approximation. Considering that these conditions assign a region of investments with expected return and variance below 100% and 100%2 , we lose a small part of generality. Inequality (3.3) denes a boundary between investments with positive and negative growth regarding its mean and variance. Hence, the principle of holding risky investments for the long-run loses some of its earlier appeal if (3.3) is not satised. If the mean does not exceed the risk increment considerably, the investor cannot rely on positive growth. Figure 2 presents the available investment opportunities in a mean-variance framework. Each investment is available on the market within and on the solid black frontier. Opportunities which provide positive growth are located in the grey area above the dashed E{x1 } = 2 1 Var {x1 } boundary. 4

Figure 2:
4

Investment opportunities with positive growth

Growth optimal investments

For investments A and B where

Var
x1

= Var

x1

and E{xA } > E{xB } 1 1

(4.1)

stand, investment A grows faster. Statement (4.1) is also an approximation since (3.1) takes only the rst and second moment into account. If higher moments are notable, (4.1) might not stand. In the introduced model, similarly to Markowitz [] and Sharpe [], the possible maximum expected relative (and rate of return) is an increasing function of variance, such as
E (c) max E {x1 |Var {x1 } = c} , x1

where E () denes the points of the so-called ecient frontier. This frontier assigns investment opportunities with maximum mean that can be achieved at a certain risk level. According to (4.1), the maximum growth investment lies on the ecient frontier if higher moments are negligible. Furthermore, we get from (3.2) by derivation that the growth optimal investment satises
1 dE (c) (2 E (c)) = dc 2

(4.2)

subject to

2 > E (c) and 1 > c.

Condition (4.2) appoints a threshold for the variance. Beyond this limit, where
dE (c) 1 (2 E (c)) < , dc 2

higher rate of return does not compensate the investors for running higher risk, and moreover, the rate of growth decreases for larger risks. (c) Figure 3 presents the dEdc (2 E (c)) function and the E{ln x1 } expected rate of growth on the (c) same axis as a function of c variance. Function dEdc (2 E (c)) is displayed by the dashed curve. The expected log returns of the investment opportunities are located within and on the frontier with the solid curve. There is no risky investment on the market with variance below c0 . According to 5

Figure 3:

Expected rate of growth as a function of variance

(c) (4.2) the expected rate of growth reaches its maximum where the dEdc (2 E (c)) function crosses the E (c) = 1 line. 2 If the hypothetical market portfolio (aggregation of all investment opportunity) lies near above the middle left side of the ecient frontier, it is likely that a growth optimal portfolio is nearly as risky as the market or odd riskier. This supposition is based on the fact that above the lower at compartment of the E{x1 } = 2 1 Var {x1 } boundary there are several good trade-os between the mean and variance which advance the long-term growth. Since the boundary is approximately linear on its lower side, it is expedient to run higher risk until an innitesimal increment of variance results in at least 1 1 c. (42E (c)) times increment of E (c), i.e E (c) growths faster than 2 Figure 4 presents the hypothetical growth optimal portfolio by the black dot and a feasible location of the market average by a dashed grey boundary labeled by M. E{ln x1 } reaches its maximum where the gradient of the ecient frontier is equal to the gradient of 2 1 c. The mean and variance of the market proxy CRSP capitalization weighted market average is annually 10.4% and 20.0%2 measured from 1989 through 2008.

Conclusion

Sequences of outstanding consecutive returns have a probability close to zero, however, they result in higher expected wealth than an investor can achieve. Despite this fact, in the case of an instrument with moderate risk and return, the pure mean approach shows little dierence from the expected log return methodology, because ln E{x1 } and E{ln x1 } are close to each other. In practise, for investments with variation approximately below 30%2 and average return between 50% and 50%, I could not measure large dierence, although the dierence exists, even in cases of highly skewed return distributions. However, after several investment periods the aggregation of these margins between ln E{x1 } and E{ln x1 } results in a signicant dierence in nal wealth. The most remarkable distinction between the mean and expected log approach traces back to an older nancial issue. We can easily see that maximization of E{x1 } according to (2.1) does not actuate diversication at all, while optimizing E{ln x1 } supports portfolio creation if it serves the interest of long-term growth. Additionally, if a diversied portfolio ensures the growth optimal capital allocation the max E{ln x1 } policy entail portfolio rearrangement since the investor could move away from the ideal 6

Figure 4:

Growth optimal and market portfolios

allocation, i.e. max E{ln x1 } is a dynamic, max E{x1 } is a buy-and-hold strategy. These two issues imply that diversication and portfolio review is not only an opportunity, it is a must in the long-run. Since the expected rate of growth is a decreasing function of the single period variance a portfolio with low level risk and moderate mean may achieve higher growth rate than an asset with superior mean. If the mean of a very risky investment does not exceed the variance increment considerably the investor cannot rely on positive growth. Even so, these risky investments may serve as constituents of the growth optimal portfolio.