Readers Have Questions About Stocks. An Economist Replies.
Lots of readers responded to my Jan. 5 newsletter discussing a new book, “Money Magic: An Economist’s Secrets to More Money, Less Risk, and a Better Life,” by the Boston University economist Laurence Kotlikoff. I’ve already responded to many of you by email but nothing beats hearing from Kotlikoff himself. I presented him with some of your questions and criticisms, and he replied. Here’s that exchange:
Larry, many readers said that there’s no reason for a long-term investor to shy away from stocks because they always go up in the long run, say, over 20 or 30 years. Your response?
This statement is wrong. There are several 30-year periods over which stocks barely rose in inflation-adjusted terms, and many 20-year periods in which they outright declined. Plus, we don’t have enough independent observations to go on. Take the two 30-year periods 1915 through 1945 and 1916 through 1946 — 28 of the annual returns in the two periods are the same, so they don’t provide new information. Unfortunately, the history is far too short to provide statistical reliability about cumulative returns over independent 30-year holding periods.
One response is to consider cumulative returns from other countries. But as Zvi Bodie, a fellow professor at Boston University, points out, Russia, China, Germany and Japan have major gaps in their data thanks to wars and revolutions. We can’t calculate how their stock markets would have fared between, say, 1915 and 1945, but it surely would have been bad. And speaking of Japan, its Nikkei 225 average fell 48 percent in inflation-adjusted terms between 1989 and 2020!
The research firm Morningstar states, “Over longer horizons, the chance of losing money in the stock market is substantially reduced.” That’s true. But if you do lose, it can be disastrous. Suppose you are blindfolded and have two options — stay where you are (hold safe bonds) or toss a die (hold risky stock). If you roll 2 through 6 you walk north a block. If you roll 1, you walk south a block. Ten blocks north is a pot of gold. Ten blocks south is a cliff. Most of the time you’ll get the gold and gloat over taking the gamble. But some of the time, you’ll fall off the cliff with no Wall Street firm to catch you.
You describe stocks as exhibiting a random walk. But some top finance economists say that after stocks drop, they have a tendency to go back up, and vice versa — regression to the mean.
There is some weak evidence for that in the data, but it can take decades to manifest. If there is any chance to make money from regression to the mean, professional traders will seize on it before you have a chance. In any case, because it’s weak, it doesn’t prevent really terrible outcomes. Wall Street’s focus is on probability, whereas economists focus on outcomes. Losing everything, not matter how low the probability, is not something an economist would ever entertain as part of a reasonable financial plan.
Larry, one reader wrote this: “Peter, you wrote, ‘Think of investing like driving a car: Statistically speaking, the chance you’ll have a serious accident over the next five years is greater than the chance you’ll have one over the next five months.’ This is not a great analogy. The chance of an accident is not greater over five years than five months because each time you get into your car and drive is an independent event.” What do you say to this reader?
Yes, each trip is an independent event and has the same odds of a major accident. But the more times you drive, the greater the risk of at least one accident. Let’s say tossing heads is bad. The probability of completely avoiding heads is 50 percent on the first toss, but only 1 in 1,000 over 10 tosses. True, the probability of ending up with more money after X years goes up the higher the share of stocks in your portfolio. But so does the probability of ending up with less than the purely safe investment. This is the dirty little secret of Wall Street.
Some readers invest in dividend-yielding stocks for income, preferring those over stocks that don’t have dividends but tend to rise in price more. Is that a sensible strategy?
Yes, if you do it right. I introduce “upside investing” in my new book as a safe and simple way for risk-averse investors to play the market. The idea is to treat all your money now instocks and all the money you’ll add to your stock holdings as if you will lose every penny of it. Then invest your remaining money in safe assets, i.e., TIPS — Treasury Inflation Protected Securities. This sets a floor to your living standard. Until you withdraw money from the stock market, you spend only the floor amount. This way, if your stocks crash and burn before you sell them, your living standard won’t be impacted. As you withdraw from the market, invest the proceeds in TIPS, which gives you more safe assets, justifying a higher living-standard floor.
Taking dividends and safely investing them is an example of “upside investing.” The key thing is never spending out of a pool of funds that isn’t fully safe. This way your living-standard floor will only rise. Versions of “upside investing” are considered in “Risk Less and Prosper: Your Guide to Safer Investing” by Zvi Bodie and Rachelle Taqqu.
Lastly, I got some emails from people who said owning a house is a good way to protect yourself from the vicissitudes of the markets. Is that true, and if so, why?
Absolutely. When you own your home you’re protected from rent increases. The shelter that the house provides is like an inflation-protected annuity you might buy from an insurance company.
It’s not true, however, that if house prices rise, you’re better off. If you sell your house you still need a place to live, and other places will have gotten more expensive. If house prices fall where you are, but rise where you want to live, you’ll get hurt.
The one big advantage, though, even if you must move, is that homes are real assets. As such, they should maintain their real value during periods, like now, of high inflation.
The readers write
I am a professor who is blind. Your newsletter on Wednesday, “How Much Deference Do Elite U.S. Colleges Deserve?” uses the term “need blind.” Using the word blind to mean not knowing something is a negative stereotype. There could be more thoughtful language used at an important newspaper like The New York Times. One could write “anonymous evaluations,” “need status unknown” and so on. One just has to be creative, apparently as creative as those Ivy League schools with their finances.
Quote of the day
“Because it demands large-scale paradigm destruction and major shifts in the problems and techniques of normal science, the emergence of new theories is generally preceded by a period of pronounced professional insecurity.”
— Thomas Kuhn, “The Structure of Scientific Revolutions,” third edition (1996)
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