STOCKS OR BONDS – IT DEPENDS ON YOUR BUSINESS
ECONOMIST Aug 23rd 2018How should they invest their money? More specifically, how much of their savings should go to bonds and how much to shares? Textbook theory says it depends on how tolerant Simon and Chris are towards risk. If either can bear the sometimes violent ups-and-downs of stock markets, he should hold more shares, which have higher rewards to go with the extra risk. Should such price swings keep him awake at night with worry, he should tilt the mix of his investments towards safer government bonds.
A risk-lover such as Simon is happy to own mostly shares. If you think skydiving is fun, you probably will not lose sleep if the value of your portfolio goes down from time to time. By the same logic Chris, who prefers a quiet life, is content to hold a bigger slug of bonds than Simon. Yet on a broader reckoning, both friends would be better advised to go against their inclinations. Simon, the banker, should buy mostly bonds. Chris, the bureaucrat, should buy mostly stocks.
If that seems paradoxical, consider the nature of each friend’s line of work. Simon’s professional fortunes are tied to the stock market. When share prices are booming, the general appetite for business risk is high. Investment projects are approved. Deals are done. The demand for the services of investment banks is strong. Simon’s bank makes pots of money and his bonus surges. His fortunes are changeable, though. When the stock market is down, the bank’s profits plunge. So his returns are high, but also volatile—like a stock. To hedge against the stock-like returns of his occupation, Simon should own bonds. In contrast, Chris enjoys a bond-like career. His salary is lower but steadier. His job is not at risk in downturns. So he can afford to take bigger risks with his investments. He should own stocks.
Your job is your down-payment
This is not to say that preferences about risk do not matter to investment choices. They do. It is that wealth should be looked at in the round. A proper reckoning would include not only financial assets but human capital—a person’s knowledge, skills and talents. This has a big influence on earnings over a working life. Young people, with few savings and decades of employment ahead, have most of their lifetime wealth embedded in their human capital. It has a payoff, just like a stock or a bond. It makes sense to take account of that when deciding what to hold as financial wealth.
This way of thinking comes more naturally to people who work in finance. There are fund managers with most of their professional portfolio in stocks but all of their personal wealth in three-month bills. If the bets on stocks turn bad, they might find themselves out of a job. They do not want to put all their personal savings at risk as well.
But most people do not think like this. The available evidence suggests that households do not attempt to hedge their employment income. In fact, they typically “anti-hedge”, by holding a disproportionate fraction of their savings in the shares of their employer or of companies in the same industry or locality.
A paper, published in 2003, by James Poterba of the Massachusetts Institute of Technology discovered that an average of more than 40% of the value of the 20 largest company-pension plans in America was invested in the firm’s own shares. The dangers of such a strategy had recently become apparent. When Enron failed, its employees had over 60% of their retirement savings in company stock. Another study based on Swedish data by Massimo Massa, of INSEAD, and Andrei Simonov, now of Michigan State University, also found that households tend to invest in stocks that are closely related to their employment income.
People stick to what they know for understandable reasons. Investment can seem like an aggressive sport, the preserve of bulls and bears or Wall Street wolves. Yet it would be more helpful to think of investment as self-insurance. People save and invest to protect themselves from contingencies. The best way to guard against some sorts of risks is often to embrace a different kind. The kind of insurance you will need ultimately depends on who you are.
Should investors diversify away from America?
The farmers knew the penalty for failing to diversify. That lesson ought to be heeded in investing, too. But it isn’t. Three-quarters of equity funds in America are held in shares listed there, according to Morningstar, a data-tracking firm. American stocks have beaten a broad index of other rich-world stocks in seven of the past ten years. Even so, it is a lot of eggs to have in one basket. Those who seek to diversify by buying a global index find they are still heavily exposed to America. American-listed stocks account for 55% of the value of the msci All-Country World Index, a widely used benchmark.
When the harvest in one place has been consistently good, people are reluctant to look elsewhere. But wiser investors follow the practice of Peru’s mountain farmers and spread their bets far and wide. America’s stockmarket cannot outperform forever. When the investment climate changes, a heavy tilt towards a single country can be costly.
In principle, investors would be best off holding a broad range of equities from many countries. In practice, they have a tendency to favour their domestic market. This “home bias” is a puzzle. Domestic equities are a poor hedge against one of the biggest hazards to wealth—the loss of a job due to a faltering economy. Of course, many firms listed in America have substantial foreign earnings. But the risk-diversification they offer is still limited. Home bias, it seems, is mostly a quirk of behaviour. Investors think of foreign stocks as more risky than they really are.
In any event, it is not so easy to follow a spread-your-bets approach. msci’s global index is weighted by the market value of its constituents. America looms large in it. This is in part because the world’s most valuable stocks are listed there. But it also reflects the nature of business ownership. In America big companies tend to be public. In other places many are family-owned. How open a country is to investors must also be allowed for. China’s weight is tiny because its market is less accessible.
And the same question invited by those field-scattering Peruvian farmers also arises. Why bother? After all, it is America’s stockmarket that makes the global weather. Were it to crash, it would take down other markets, too. Research by Cliff Asness, Roni Israelov and John Liew of aqrCapital Management finds that in a panic, all markets get trampled. In October 1987, when American stocks fell by 21.4%, a global portfolio of 22 equally weighted equity markets fell by 21%.
Over time, however, returns are driven by fundamentals in each economy, and the global portfolio performs better than the worst-hit individual market. A portfolio that is weighted by market capitalisation, like the msciindex, is a less potent diversifier. But it is still far better than being over-exposed to one bad market.
Those seeking the ideal balance of risk and reward should prefer to own shares of firms in proportion to their importance to the world economy. But ordinary investors should also like to keep things fairly simple. A good investment rule, then, might be to allocate a third of an equity portfolio to American stocks, a third to an index of stocks listed in other rich countries and a third to emerging-market shares. Such a portfolio would better reflect the make-up of global gdp. It would cap exposure to any one bloc. And it would anticipate a secular shift. As more emerging-market stocks are added to the global index, says Victor Haghani, of Elm Partners, America’s weight will diminish.
Investors following such a rule must sacrifice some of the ease of buying and selling American equities for somewhat less liquid markets. The other big drawback is that when American stocks do especially well, a more diversified portfolio has lower returns than the global benchmark. Peruvian farmers would be prepared to live with that. By spreading their bets, they suffered lower yields than they would have had they only planted in the best field. But they could never have been sure in advance which was the right field to pick.
When does the case for long-term investment make sense? Time horizons matter less than commonly thought
Oct 11th 2018 Economist
One lunchtime around 1960 a a professor proposed a wager to a colleague. Flip a coin an call “heads” or “tails”. If you can right, you win $200. If you call wrong, you pay $100. This is a favourable bet for anyone who would take it. Even so, his colleague refused. He would feel the loss of $100 more than the gain of $200. But he would be happy, he said, to take 100 such bets.
The professor who offered the bet, Paul Samuelson, understood why it might be refused. A person’s capacity for risk could no more be changed than his nose, he once said. But he was irked by his colleague’s willingness to take 100 such wagers. Yes, the likelihood of losing money after that many tosses of the coin is vanishingly small. But someone who takes very many bets is also exposed to a small chance of far bigger loss. A lot of bets, reasoned Samuelson, were no safer than a single bet.
To understand the debate, start with the law of large numbers. It means that the more often a favourable gamble is repeated, the more likely it is that the person who takes it comes out ahead. Though a casino may lose on a single spin of the roulette wheel, over a large number of spins its profits are determined by the slight advantage in odds (the “house edge”) it enjoys. But a casino that would take a hundred $100 bets would not refuse a single bet of the same size. That was part of Samuelson’s beef. If his colleague dislikes a single bet, after 99 bets he should refuse the 100th. By this logic he should also refuse the 99th bet, after 98 bets. And so on until all bets are spurned.
Only a naive reading of the law of large numbers would support a belief that risk is diminished by more bets, said Samuelson. The scale of potential losses rises with the number of bets. “If it hurts much to lose $100,” he wrote, “it must certainly hurt to lose 100 x $100.” Similarly, it is foolish to believe that by holding stocks for the long haul—taking multiple bets on them—you are sure to come out ahead. It is true that stocks have usually yielded higher returns than bonds or cash over a long period. But there is no guarantee they will always do so. Indeed if stock prices follow a “random walk” (ie, an erratic and unpredictable path), long-term investing holds no advantage, said Samuelson.
This logic begins to fray if you relax the random-walk assumption. Stock prices appear to fluctuate around a discernible trend; they have a tendency, albeit weak, to revert to that trend over very long horizons. That means stocks are somewhat predictable. If they go up a long way, given enough time they are likely to fall, and vice versa. In that case, more nervous sorts of investors are able to bear a higher exposure to stocks in the long run than they would be able to in the short run.
Samuelson’s reasoning also assumes that people’s taste for risk does not vary with how rich or poor they are. In reality, attitudes change when a target level of wealth is within reach (say, to pay for retirement or a child’s education) or when outright poverty looms. When such extremes are far off, it is rational to take on more risk than when they are close. The calculus also changes with a broader reckoning of wealth. Young people, with decades of work ahead, hold most of their wealth in “human capital”, their skills and abilities. This sort of wealth is a hedge against riskier kinds of financial wealth. Indeed the more stable a person’s career earnings are, the greater the hedge. It follows that young people should hold more of their wealth in risky stocks than people who are close to retirement.
Samuelson vigorously disputed the dogma of long-termism, which says that the riskiness of stocks diminishes as time passes. It doesn’t. That is why long-dated options to insure against falling stocks are dearer than short-dated ones. The odds of winning favour risk-takers over time. But they are exposed to big losses in the times when they lose. Still, it would also be dogmatic to say that time horizon does not matter. It does—in some circumstances. What Samuelson showed is that it matters less than commonly thought.
Why simple rules are best when spreading your investment bets – Rebalancing stops portfolios becoming riskier or safer than desired
The emergence of low-cost indexed funds has made it easy to be this kind of know-nothing investor. Yet there is still a decision to make, namely asset allocation. How much of a portfolio should be in risky stocks and how much in safe bonds? In theory the split depends on expected returns, volatility (how much asset prices fluctuate), the investor’s appetite for such volatility—and even the investor’s age and job. Thankfully Graham had a simpler answer: a 50-50 split between stocks and bonds, maintained by adjusting as required by market prices.
The merit of this approach—or indeed the 60-40 rule favoured by many pension funds—is simplicity. There is a better chance of sticking to a simple, fixed-weights rule than a complex one. Deciding on the right portfolio weights is not the most important part of asset allocation. What matters is sticking to whatever weights are chosen. And that requires regularly rebalancing your portfolio.
All this would seem to go against a lot of market wisdom. “Cut your losses and let your winners ride” is a doctrine for the hedge-fund traders who bet on short-term shifts in market prices. Rebalancing does the opposite. Recent winners are cut in favour of more exposure to recent losers.
Yet the two approaches can be reconciled. Short-term “directional” trades—that the dollar will fall or oil prices surge, say—are highly speculative. The premise behind them might be wrong. So it is best to cut losses quickly. If a forecast is right and prices veer in a new direction, they often travel a long way. In which case, it is best to let winning trades run. Rebalancing, in contrast, is a strategy for the long term. It is a bet that extremes in market prices will be corrected eventually.
Andrew Ang of BlackRock offers an example of how rebalancing works, drawing on the 15 years between 1926 and 1940, which included the 1929 crash and the Depression. A $1 investment in stocks in January 1926 was worth $1.81 by December 1940 (after some extreme ups and downs). Bonds did better. A dollar invested in 1926 was worth $2.08 by 1940. A buy-and-hold portfolio of 60% stocks and 40% bonds in 1926 left untouched would be worth just $1.92. But a 60-40 portfolio, rebalanced every quarter, would be worth $2.46, beating both stocks and bonds (see chart). Rebalancing pays off because it cuts back on equities when they become dear and adds to them when they become cheap.
This is not an easy policy to follow. It goes against instinct to buy assets that have fallen heavily in price. But having a clear and simple strategy helps. It has parallels with other goals that require personal discipline, such as staying fit. “It doesn’t really matter whether you are swimming, playing tennis or running,” says Mr Ang. “What’s really important is getting into the habit of making a regular time to exercise.” If a rebalancing habit is established in calm markets, it will be much easier to follow when markets become stormy. How often should you do it? It is best to put a date in your diary for once a quarter, says Victor Haghani of Elm Partners. Indexed funds can be traded quite cheaply. But a lot of rebalancing can be done by diverting the flow of regular savings into the underweighted asset.
Not everyone can manage this. Indeed, rebalancing is effective because it works against the boom-bust cycle. Different weights will lead to different paths of returns. But what really matters is not the nature of an investment rule. It is whether you can stick to it. So keep it simple
Short-sellers are good for markets
The tweets in question, like many of Mr Musk’s market-moving social-media posts, were targeted at short-sellers, who aim to make money by selling borrowed shares and buying them back later at a lower price. With a quarter of its publicly traded shares lent out to facilitate short-sellers’ bets, Tesla is one of the most heavily shorted companies in America. Mr Musk has publicly feuded with short-sellers for years, calling them “haters”, “jerks” and “not supersmart”. Research suggests that such insults are undeserved. Short-sellers are savvy investors who help to keep the market’s exuberance in check.
Academics say such accusations are far-fetched. Studies that look at when short-sellers place their bets find that they behave much like other investors. Price declines that make short trades profitable tend to endure, undermining claims of manipulation. By seeking out overvalued assets, short-sellers help rein in animal spirits and prevent bubbles from forming. They make markets more liquid: when short-selling is banned by regulators, bid-ask spreads—the difference between the price at which shares are bought and sold, widely used as a measure of market liquidity—increase.
The shorts can also root out malfeasance. Jim Chanos, a well-known short-seller who is one of those betting against Tesla, famously predicted the collapse of Enron, an energy-trading firm that went bust in 2001.
Shorts’ bets do not always pay off immediately. Ihor Dusaniwsky from S3 Partners, a financial-technology and analytics firm, thinks that Tesla’s short-sellers are sitting on unrealised losses of close to $3.5bn since the start of 2016. So far this year, borrowing fees alone have cost them more than $200m.
Although short-sellers endure long stretches in the red, as a group they are clever stock-pickers. Studies show that heavily shorted stocks underperform lightly shorted stocks by as much as 16% a year on average. It was once thought that short-sellers profited mainly from bets on near-term price movements lasting no more than a month. But recent work by researchers at the University of Missouri and Renmin University in China suggests that opportunities for generating returns can persist for as long as a year. The authors estimate that a tenth of short positions last for at least six months.
Mr Musk has demanded that short-selling “should be illegal”. He has repeatedly vowed to “burn” Tesla short-sellers and “explode” their bearish positions. Recently, though, he has done the opposite. His tweet on October 4th, which mockingly referred to the SEC as the “Shortseller Enrichment Commission”, made short-sellers a whopping $645m. According to Mr Dusaniwsky, the company’s nay-sayers are convinced the stock is still overvalued. The shorts will not be exiting their positions any time soon.
