|Arnold Kling Essays | Short Book Reviews | Favorite Links | Under the Radar | Home|
by Arnold Kling
March 12, 2001
One of the more striking ads on this year's Super Bowl was from E*Trade. It was disingenuous on many levels.
The ad showed a monkey behaving like a cowboy passing through a ghost town. The ghost town consisted of Internet stocks. The ad ended by saying, "Invest wisely."
Of course, few companies were as much a product of the Internet Bubble as E*Trade. Many of the people who bought Dotcom stocks and lost money on them probably did so through E*Trade. The fact that it maintains solvency in spite of the losses that were incurred by those customers strikes me as an unseemly subject for sarcasm.
Moreover, like any stock broker, E*Trade makes its money from the frenetic activity of fools. Wise investors, who trade infrequently, would put E*Trade out of business.
Economists are properly modest about their abilities as speculators, but we do know something about wise investing. Eight of the first forty Nobel laureates in economics made constributions to the theory of finance. Merton, Scholes, Markowitz, Miller, and Sharpe were honored primarily for those contributions. On the other hand, the outstanding financial insights of Modigliani, Tobin, and Samuelson were relatively minor parts of their overall work.
(In fact, the high proportion of finance Nobels is a temporary aberration. It just happened that a lot of important research was done in finance in 1955-1975, and it is that cohort of economists who were considered for the Nobel Prize in 1970-2000. Among eminent economists who were known for non-finance work, the earliest ones died before the advent of the economics Nobel in 1969. Younger ones will become "eligible" as they accumulate more publications.)
(Two of the Nobel-winners were involved in some way with Long Term Capital Management, a failed hedge fund. However, that fund did not follow the practices recommended below.)
How do economists differ from average investors?
We prefer to buy and hold. We believe that it is difficult or impossible to outsmart the market, so that trading simply runs up transactions costs. Also, in a rising market, the more often you trade, the more you pay in capital gains taxes.
About fifteen years ago, someone studied the holdings of professors in their pensions plans. Professors in disciplines other than economics were heavily invested in fixed-income assets. The economists were virtually alone in having more than half of their assets in equities.
These are funds that try to mimic the performance of major stock indexes, such as the S&P 500. There is strong evidence that on average the index funds outperform other mutual funds. However, most non-economists fail to appreciate this evidence.
Suppose that you start out happy with a portfolio in which 20 percent of your assets are invested in a risk-free fund that earns a fixed rate of return. The other 80 percent of your portfolio is in a broad index fund. In other words, your stock portfolio is highly diversified.
To simplify matters, let the risk-free return be zero, and suppose that the risky assets earn five percent on average. In that case, with your overall portfolio, your expected return will be eighty percent of five percent, or four percent. Your risk will be somewhere in between zero and the risk of the risky assets.
Now, suppose that you decide that you would like to increase your expected return, and you are willing to take more risk. Most people seem to think that the way to do this is to exchange the stock index fund for a more concentrated portfolio of stocks.
In fact, the way to increase your expected return with the least increase in risk is NOT to concentrate your portfolio. The most efficient method is to increase your holdings of the index fund and cut back on your holdings in the risk-free investment. (The superiority of a diversified portfolio actually can be proven mathematically, but I do not know a proof that does not require getting into matrix calculus.)
An even better buy than TIPS are the I-bond series of U.S. savings bonds. Like TIPS, the I-bonds offer inflation protection. However, I-bonds are subject to less ongoing taxation. No individual is allowed to purchase more than $30,000 in I-bonds.
The "real" return on stocks is expected to be the inverse of the price/earnings ratio. If the P/E ratio were 25, then stocks can be expected to earn 4 percent. As P/E ratios soared in recent years, economists could not help noticing that they could earn a higher expected real return on TIPS than in the stock market.
The fact that TIPS offer a risk-free yield that is as high or higher than the expected return on stocks is an indication that the stock market has become over-valued. Many economists are reluctant to come to such a conclusion, because we do not believe that we can outsmart the market.
One economist who tried to balance professional modesty with his concern about over-valuation is Robert Shiller. He wrote Irrational Exuberance about the overall bubble in the stock market, and he had the good timing to publish it last March, near the peak of the NASDAQ.
Economists are insulated from plunging into "story" stocks in part because of our strong belief in diversification and index funds. Moreover, during the Dotcom heyday, we were calculating Tobin's "q," which is the ratio of a stock price to the cost of replacing the underlying capital in the firm. This ratio seemed to be ridiculously high for the Dotcoms.
I cannot promise that this strategy will prove to be optimal. However, it is a strategy that would be comfortable for most economists. Even though it is not very comfortable for E*Trade.