Home > investment > The Noble Ostrich and Other Investment Myths

The Noble Ostrich and Other Investment Myths

October 6, 2008

While sophisticated bankers and their wealthiest clients continue to take a pass on investments with even the slightest hint of risk, it seems strange that many investment advisers continue to sing the same soothing lullaby to individual investors:  “No need to panic, remember, you’re investing for the long run.  And that is what stocks are for!  If you get out now, you will miss the ups as well as the downs.”

Now I am certainly not advising you to panic (in fact, I am not advising you at all, because I am a mere finance professor, not a certified investment advisor).  But it does seem like a good time to revisit what we know (and don’t know) about personal investments and asset allocation, and to try to reassure you that there is no dishonor in prudence.

There is no formula that can tell you the right way to allocate your savings. There is a risk-return tradeoff.  Investing in risky securities, like stocks, increases your expected returns, but at the cost of higher risk exposure.  Advice like, “put a percentage of your savings equal to 100 minus your age into the stock market” are marketing prescriptions that are absent from the pages of reputable finance texts.

Where you draw the line on risk and return is a personal choice.  And you can change your mind.  It is not your patriotic duty to invest in the stock market, and it does not make you a fool not to. I cringed the other day listening to Terry Savage, a well-respected investment adviser and national commentator, talking about how everyone needs some “chicken money.”  While acknowledging that safe investments help investors sleep better at night and might even be useful beyond that, she not so subtly uses this pejorative to generically mock conservative investment strategies.  Well, all I can say is “pluck.”

Market volatility varies over time. Right now it is extraordinarily high.  Presumably prices have adjusted to reward investors for bearing this volatility.  In other words, part of the fall in stock prices can be seen as compensation for the increased risk, and a sign of higher expected returns going forward.  But we all have to decide whether the collective view of risk and return that is reflected in current prices makes personal sense.  If you have a stomach for volatility, this may look like an attractive buying opportunity and it may be a good time to increase your allocation to stocks.  If roller coasters are not your thing, a move to a more conservative asset allocation may be in order.
Stock prices are not mean-reverting. The catch-phrase “stocks are for the long run” unfortunately seems to suggest that if stock prices drop, it doesn’t really matter because they will catch back up.  That is not what the statistics of stock returns imply. As a first approximation, stock prices are best described as a random walk with positive drift.  When a stock’s price falls, that is its new and permanently lower starting point.  Over time returns will be positive on average, but there is no force that erases past loses.

Also, the long-run can be very long indeed.  Today the Dow Jones is back to where it was almost a decade ago, in the spring of 1999.  Had you put $100 in stocks, you’d have $100 today.  Had you put it in a “chicken money” bank account earning 2% after inflation, you’d have about $120.  And I have been wondering, when did commentators start confusing bank accounts with mattresses?

Asset allocation is reversible. It is true that if you pull back from the market you lose the opportunity for gains as well as losses.  Moving to a more conservative asset allocation is a way to avoid risk, and there is no telling if by so doing you also avoid the next big run-up.  If you do decide to back off, it is better to think of it as a time out than as a permanent retreat.  Remember that if you exchange $1 of stocks for $1 of bonds, what you have in either case is a dollar of value today.

Diversification is critical for reducing risk, but it does not eliminate it. You can avoid a lot of risk by holding a diversified portfolio of risky assets, rather than individual stocks.  Investing in funds like Vanguard’s 500 Index allow you to get broad stock market exposure while incurring low transaction costs, even with a relatively small investment.

Once you get rid of the risk of individual stocks, lots of risk remains.  Unfortunately, a quick glance at the markets in the last few months confirms this fact.

A final thought on investing and the greater good. I expect to get some major pushback for having written this, if for no other reason than that if everyone sits on their money and reduces their investments in stocks, a decline in market prices becomes a self-fulfilling prophecy.  While I agree that the world would be a happier place if everyone settled down and resumed investing as usual, I don’t think the common investor should have to bear the burden of being the first to make it happen.

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Categories: investment
  1. Irax
    October 7, 2008 at 3:05 pm

    Nice post – I particularly like the part about stock prices not being mean-reverting. This is something that in general investment advisers are not eager to point out. One factor that you do miss out is sunk costs. At any point, the money lost on an investment is better considered sunk cost.

    Admitting that an investment actually has lost money by closing a position seems to be psychologically much tougher than looking at the loss as a paper loss with hope of regaining in the long run.

  2. Robert Murray
    October 7, 2008 at 3:56 pm

    Hi Professor,
    Thanks for a really timely piece without a single Greek-letter-filled equation! Your comment about diversfication is so true. Even once stable sectors like leveraged loans and investment grade corporate bonds have taken a hit this year. Perhaps the mattress is not such a bad place after all.

  3. saitu
    October 10, 2008 at 5:06 am

    Hi Professor,

    Thanks for such a clear message. Bothe govt. and the individuls have to pick a point from here.

  4. James Rich
    December 5, 2008 at 4:54 pm

    Professor Lucas –

    I am a loyal reader of your blog (and loved your Fixed Income class at Kellogg!). I thought about this entry on investment myths today while reading an article on Bloomberg. Guess which of the following asset classes has performed the best over the past 10 years (as of 12/5/08):

    Stocks
    Corporate Bonds
    Government Bonds
    Real Estate
    Commodities
    Cash

    The answer certainly surprised me: government bonds. And guess which performed the worst? You guessed it: stocks.

    I have friends and family members who live by investment myths like the “100 minus your age” rule that you cited above or swear by the investment style presented by Jeremy Siegel in “Stocks for the Long Run.”

    Clearly there are times when certain asset classes will outperform others, but it seems to me that this supports your argument that investing requires diligent and active management between asset classes and securities rather than just adhering to silly investment myths.

    …either that or, if you’re really lazy, investing blindly in the safest assets in the world: U.S. government securities.

  5. Jason Kamler
    December 22, 2008 at 3:33 pm

    As a financial consultant, I found the narrow definition of risk problematic because it ignored two other risks that individual investors face—longevity and inflation. The implied definition of risk that your blog uses is the loss of principal. While this risk obviously exists, it pales in comparison to the very real likelihood of individual investors losing purchasing power over time or running out of money during retirement. If the “average” investor creates an asset allocation model that makes them comfortable today by ignoring equities in favor of government securities, they are almost certainly going to put themselves in the position of having an underfunded retirement in the future.

    This blog links market volatility with risk when the two are not identical. Unless an investor needs to use the invested money in the short term, the daily market gyrations should, in theory, have no effect on their long term investment strategy or plan.

    Asset allocation and the need to revisit that allocation is essential for long term investment success. But, the realization that risk entails more than short term price fluctuation is equally as important.

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