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How to Reduce Risk in Your Stock Portfolio

by Kimberly Vavrick Friday, November 20, 2015

The impact of inflation on asset prices is one of the most researched questions in finance. Both scholars and speculators want to identify economic indicators with the most value for predicting upturns—and downturns—in financial markets.

bjorn eraker finance wisconsin school of business university of wisconsin

Bjørn Eraker, Bill Nygren Chair in Investments and Associate Professor of Finance at the Wisconsin School of Business.

Bjørn Eraker, associate professor in the finance, investment, and banking department of the Wisconsin School of Business, and his co-authors identified new evidence that inflation affects the durable goods economic sector more than either the non-durable goods sector or the overall economy.

This seems like common sense: durable goods are items that we do not need to survive, like a new television set, while non-durable goods are items that we purchase no matter what the economic climate, like food or natural gas.

Eraker and his co-authors developed mathematical models to explain this phenomenon in a recent paper, “Durable Goods, Inflation Risk, and Equilibrium Asset Prices,” by examining stock prices in relation to both inflation and “expected inflation.”

Eraker recently sat down with the news team at the Wisconsin School of Business to discuss their findings.

WSB: What was the impetus for the paper?

Eraker: I wrote this paper along with Wenyu Wang, who was a student of mine and graduated in 2013. He’s now an assistant professor at Indiana University’s Kelley School of Business. Another co-author, Ivan Shaliastovich, who also was a student of mine and is now assistant professor of finance at the Wharton School at the University of Pennsylvania.

Our research is part of this agenda where people are trying to put together mathematical models that can explain the puzzle pieces of what we know about how financial markets work as much as possible, and how financial markets reward people over time for taking certain risks.

WSB: What did you find?

Eraker: The core of our research is that we are trying to understand business cycle dynamics. We are looking at inflation and shocks to what we refer to as expected inflation.

It’s known that inflation tends to have a negative impact on durable goods consumption; and we are trying to understand how these shocks affect the pricing of various assets.

We separated the data in two groups of stocks: companies producing a durable good, such as a washing machine, and companies producing a non-durable good, like breakfast cereal.

The durable goods are much more business-cycle-sensitive than are the non-durable goods, and the stock for durable goods tends to do worse in recessions.

The intuition for this is pretty simple. We‘re going to put off some extraneous purchases; the new golf bag, those types of things, but we are still going to eat, even if we have to eat a little less.

This is a very basic example, the model developed offers much richer insights than that.

WSB: How did you dig into it?

Eraker: We looked at an empirical data set of consumer spending data on durable and non-durable goods from Q1 1963 to Q4 2006.

Then we formulated a model of nominal stock prices for firms that produce durable and non-durable goods, as well as bond prices based on long-run risk.

One of the key features of our research is the fact that we included agents in the model that have utility from consuming both type of goods. Existing literature doesn’t typically have models that include data for different types of goods, and that’s what makes our research unique.

WSB: What else does your model show?

Eraker: We also fit the returns of nominal bonds into our model. This quantitatively accounts for the key features of the nominal bond and equity price data and in particular, the difference in levels, volatilities, and the correlations of equity returns in durable and non-durable goods sectors with expected inflation and bond returns.

WSB: What are some practical takeaways from your research?

Eraker: I think it’s just understanding that these consumer durable goods companies have more systemic risk than people maybe think about.

I like to think that people with a very long-term investment horizon, like young people saving for retirement, are better off taking risks with their investments than old people.

For older folks it probably makes sense to not load up on the durable stuff, because if there is another financial crisis, those stocks will have a larger negative rate of return in that scenario. And vice versa, if you’re a young person, you can load up on durable goods stocks and in the long run get a higher rate of return.

Read more about Earker’s research on “Durable Goods, Inflation Risk, and Equilibrium Asset Prices.”