Why "The Long Run" Still Matters in Choosing Stocks

Unfortunately, I was just rejected for a letter I submitted to the Economists' Voice, which was responding to a letter by Boston University financial economist Zvi Bodie.

Well, that's the breaks. At least I didn't get a form letter. Berkeley economist Aaron Edlin responded, writing, "My own take on Zvi Bodie's point suggests that you are heading at a tangent.  Not an uninteresting tangent, but nonetheless a tangent."

So anyway, in the hope that you too will find my letter not uninteresting, I am printing it below. And, in fact, I really do think it makes important points.

Letter: Why "The Long Run" Still Matters in Choosing Stocks

By Richard H. Serlin

Dear Editors:

In Zvi Bodie's letter, "Are Stocks the Best Investment for the Long Run?", he makes the argument that although the probability of a cumulative return less than the average becomes much smaller over the long run, the potential total dollar loss becomes much greater. He also mentions, "Paul Samuelson’s rebuttal of the conventional 'stocks for the long run' argument". Indeed Samuelson did prove in a 1969 paper that with some standard utility functions and assumptions typically used in economics and finance, the optimal percentage invested in risky stocks does not depend on the investor's age or time horizon. In Samuelson's model whether the investor is 22 or 62 makes no difference in the optimal percentage of stock in his portfolio.

While this model did give some important insights, like all models, it's only as good as its interpretation, and as usual, the most intelligent interpretation is not literal. First, the model assumes away potential short-term liquidity problems, like inability to pay the mortgage or children's tuition, or inability to weather a job loss or serious illness. Next, it assumes that an individual's level of risk tolerance is constant throughout life, when in fact, a healthy young person can tolerate a large loss of wealth far better than a senior.

The model also assumes that the utility an individual receives depends only on his current wealth, or income. In reality, the utility an individual gets from his current income depends greatly on what his income used to be, and on the incomes of his peers or reference group. An individual will be far happier with an income of $100,000 per year if he has spent his life at $100,000 or less, than if he has spent his life at $500,000 or more. He will also be far happier with a $100,000 income if the incomes in his reference group (family, friends, neighbors, perceived peers) are $100,000 or less, than if they are $500,000 or more (for an overview of the evidence see Frank, 2007).

Why does all of this make the time horizon and age of an investor important in deciding what proportion of his savings to invest in stock? If an investor is 60, and he invests all of his savings in stock, then if the stock market loses 50 percent in a year, as it has recently, he may not be able to afford important medical care, or otherwise may not be able to take care of himself properly. This is far less likely to be true of a healthy 25 year old. In addition, at 25, if there is a large loss in the stock market, an investor can hold off on, or slow down, increases in consumption, so that his lifetime consumption will stay steady, or better yet steadily increase. An investor of 60 having long grown accustomed to living on $100,000 per year, and with his working years coming to a close, will not be able to do this. He may have to suddenly spend the rest of his life consuming at an income far lower than what he has long grown accustomed to.

With regard to the consumption of others, if an individual is investing heavily in safe T-bills with an expected inflation adjusted return of 0.7 percent, while his reference group is investing heavily in stocks with an expected inflation adjusted return of 6.8 percent (see Siegel 2008), then over time his reference group, and indeed society as a whole, will likely grow multiples wealthier than he with the power of compound return, and this will typically greatly lower his utility (see Frank 1999 and 2007). If, however, stocks crash, they also do so for his peers, so he maintains his relative position. It's a "we're all in the same boat" situation (You may ask, if everyone invests in stock, will this substantially bring down the return of stock anyway? Not necessarily, not if the flexibility of stock simply allows firms to create more wealth than they can with bonds; see Serlin 2008.)

In the literature I have not seen these factors considered in a lifetime portfolio model. I believe this is partly due to an overvaluing of mathematical ease relative to realism, and partly due to a bias against considering positional/context/prestige factors, despite the great effect they have on utility and behavior (see Frank 2005).

Richard H. Serlin
Adjunct Professor
University of Arizona
President
National Personal Finance Education
Tucson, AZ, USA

REFERENCES AND FURTHER READING

Bodie, Zvi (2009) "Letter: Are Stocks the Best Investment for the Long Run?," The Economists' Voice: Vol. 6 : Iss. 3, Article 3. DOI: 10.2202/1553-3832.1488. Available at: http://www.bepress.com/ev/vol6/iss3/art3

Frank, Robet H. (2007) Falling Behind: How Rising Inequality Harms the Middle Class. Berkeley, CA: University of California Press.

Frank, Robet H. (2005) "Positional Externalities Cause Large and Preventable Welfare Losses," American Economic Review, Vol. 95, No. 2: 137-41. May

Frank, Robert H. (1999) "Our Climb To Sublime; Hold On. We Don't Need to Go There," The Washington Post. January 24th. Available at:
http://www.robert-h-frank.com/PDFs/WP.1.24.99.pdf

Samuelson, Paul A. (1969) "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, Vol. 51, No. 3: 239-246. August.

Serlin, Richard H. (2009) "Supply Side Explanation of the Equity Premium Puzzle," Working Paper. Available at: http://works.bepress.com/richard_serlin/18

Siegel, Jeremy J. (2008) Stocks for the Long Run. 4th Ed. New York, NY: McGraw Hill.

Important Policy Note

Please see the important policy note I have added to the left sidebar:

I edit and improve most of my posts after I initially place them....I will, however, note if I have made a major change of opinion, or corrected an important mistake of fact that could be substantially harmful to a person or party. This is subject to interpretation...

My last post, for example, has undergone a great deal of editing. It's difficult to explain how, and how much, an MBA is valued in academic economics and finance in a short space without being misconstrued. I added a lot of qualifiers and caveats, so that now I think it's a lot more accurate and less likely to be misinterpreted.

What economists without MBAs aren't taught

Nicholas Kristoff has an outstanding New York Times Column today, "Health Care That Works":

Health care reform may be defeated this year in part because so many Americans believe the government can’t do anything right...Yet the part of America’s health care system that consumers like best is the government-run part.

Fifty-six to 60 percent of people in government-run Medicare rate it a 9 or 10 on a 10-point scale. In contrast, only 40 percent of those enrolled in private insurance rank their plans that high.

Multiple surveys back that up. For example, 68 percent of those in Medicare feel that their own interests are the priority, compared with only 48 percent of those enrolled in private insurance...
In truth, despite the deeply ingrained American conviction that government is bumbling when it is not evil, government intervention has been a step up in some areas from the private sector.
Until the mid-19th century, firefighting was left mostly to a mishmash of volunteer crews and private fire insurance companies. In New York City, according to accounts in The New York Times in the 1850s and 1860s, firefighting often descended into chaos, with drunkenness and looting.

So almost every country moved to what today’s health insurance lobbyists might label “socialized firefighting.” In effect, we have a single-payer system of public fire departments.
We have the same for policing. If the security guard business were as powerful as the health insurance industry, then it would be denouncing “government takeovers” and “socialized police work.”...

...the government has a particularly good record in medical care.

Take the hospital system run by the Department of Veterans Affairs, the largest integrated health system in the United States. It is fully government run, much more “socialized medicine” than is Canadian health care with its private doctors and hospitals. And the system for veterans is by all accounts one of the best-performing and most cost-effective elements in the American medical establishment.

A study by the Rand Corporation concluded that compared with a national sample, Americans treated in veterans hospitals “received consistently better care across the board, including screening, diagnosis, treatment and follow-up.” The difference was particularly large in preventive medicine: veterans were nearly 50 percent more likely to receive recommended care than Americans as a whole.

“If other health care providers followed the V.A.’s lead, it would be a major step toward improving the quality of care across the U.S. health care system,” Rand reported.

As for the other big government-run health care system in the United States, Medicare spends perhaps one-sixth as much on administration as private health insurers, although the comparison is imperfect and controversial...

On my blog, foreigners regularly express bewilderment that America may reject reform and stick with a system that drives families into bankruptcy when they get sick. That’s what they expect from the Central African Republic, not the United States.

Let’s hope we won’t miss this chance. A public role in health care shouldn’t be any scarier or more repugnant than a public fire department.

I'd like to add to this:

I think what is a significant problem affecting many economists, especially the freshwater (conservative) variety, is that they have little or no real world business experience, and real world experience and MBAs are, on average, of little value in academic economics publishing or advancement. It's complicated and nuanced how and why this is true. It's hard to explain in a few sentences. But basically, advancement is almost all based on publication. And the vast majority of publications are done just by accepting the prevailing assumptions, models, econometric techniques, and framework, and then doing some extensions or probes, data exploring, or new incremental models within that framework or paradigm, or even very new, but still very sterilized models, that focus on mathematical advance and elegance, things that don't require much more, or deeper, real world creativity and intuition. All this can still be very valuable – if interpreted intelligently, but summing up, a masters in mathematics or statistics is usually much more valuable for advancement in academic economics than an MBA, so only a minority of academic economists have MBAs. The same is even true for academic finance professors.

Please don't get me wrong, though, a Ph.D. in economics is immensely more valuable for understanding the economy as a whole, as opposed to just how to make a single business profitable, than an MBA or real world business experience. It's just that those things can add certain insights that aren't explicitly taught in economics Ph.D. programs, although they can clearly still be deduced with high level intelligence and a willingness to use it by a non-MBA, non-business experienced economists.

Anyway, an economist who got an MBA, and I did, The University of Michigan, 1998, especially at a top school, would learn in his classes that subcontracting is not always better just because there may be competition for the work. It's a tradeoff. There are costs as well as benefits, and often the costs swamp the benefits. A big cost is that it can be very hard – and time consuming and expensive – to monitor and quality and otherwise control an outside contractor, especially a giant spiders web of outside contractors for almost everything. And coordination costs can be huge. All this can be far easier and cheaper if done in house. This applies to any organization, government as well as a private company.

Few economists go to MBA school and are taught this, and far too many economists just assume that the extremely simplified and assumed away models are exactly reality, or qualitatively exactly reality, and so turn off their high level intelligence and don't think about this, and things like it, that so often don't exist in models, or are explicitly assumed away.

In addition, as the world has gotten more advanced, economies of scale have gotten to be more and more prominent, and the benefits of economies of scale, as can be had in a government run program, can swamp the benefits of having many small fragmented competitors.

Moreover, there are what I would call economies of simplicity, like when there is just one single payer insurer, medical providers don't have to spend enormous money and time learning the many forms, procedures, rules, and coverages of the many fragmented insurers in our system. And a patients complete medical records, all of it, can be stored in just one easily accessible central location, not just lowering costs, but also improving information available to doctors, and therefore treatment. Complication costs can be enormous. I teach one of the largest university personal finance courses in the country, and am president and co-founder of one of the largest personal finance education companies, so I can tell you, the amount of hours that people have to spend learning personal finance to avoid tricks, traps, and other errors that can be ruinous in our highly complicated system is huge, and largely unnecessary. It's a great deal of time that could have been spent producing, or with one's family.

Thus, it's a tradeoff; the private sector is not always best, as too many economists dogmatically assume. For most things it is, but often it isn't. Often a combination is best, but that best combination may be largely government. And, in fact, a combination of some kind is almost always best in that societal efficiency is almost always improved with at least some government role, like at least antitrust law and basic regulation like truth in advertising.

And, I haven't even, at least explicitly, mentioned that in the presence of great asymmetric information and externalities (as well as many other well established in economics market problems), a profit incentive can actually be very non-invisible hand (as Adam Smith, in fact, understood, despite the popular, and propagandized, misconception). A profit incentive in this case can be a strong incentive to do things that hurt customers and society greatly.

A key reason why 50 Democratic senators and the V.P. should permanently eliminate the filibuster

One of the strongest arguments why eliminating the filibuster would do far more good than bad, and why 50 Democratic senators (that's all that's needed, plus the V.P.) should eliminate the filibuster through rulings from the chair, and then strike down from the chair all Republican tactics to shut down the senate (all do-able, see Kevin Drum's Mother Jones post, "Filibuster Wanking", Thomas Geoghegan's current article in the Nation, "The Case for Busting the Filibuster", and the 2006 book "Filibuster" by Columbia political science professor Gregory Wawro and Harvard government professor Eric Schlickler, page 272 for example) is this:

The great good the Democrats would do with the filibuster eliminated – things like universal healthcare, or perhaps someday Medicare for all, free four years of college (we've been stuck at free education only up to high school for over 100 years, while the amount of education necessary to be a highly productive nation has skyrocketed in that time), and much more – once enacted, and people saw the truth of how good they were, as opposed to the Republican propaganda, would be permanent. The Republicans would never dare get rid of them, and if they did, it would be very temporary; next election, the Republicans would be decimated, and the programs would be restored easily.

A good example is Medicare (universal single-payer health insurance, like in Canada and France, for our seniors). The Republicans, led by Ronald Reagan, fought it tooth and nail in 1965, claiming it would lead to socialism, or worse. Today they would not dare even mention repealing it, because once it was actually passed, people saw how much better it really made their lives, and loved it.

By contrast, the things the Republicans would push through with 51 votes would usually be bad, or horrible, to the vast majority, and so once people actually experienced them, and saw firsthand how the lies about them were really false, like how they, in fact, only helped the rich, they would not last. The public would vote for change, and they would be repealed, AND the Republicans would be revealed. People would see firsthand that lies like trickle down were false, a devastating fairy tale, eventually. For some things they would see very quickly, for others over more time. And, the repeal of harmful Republican policies would be much easier without the filibuster because it would only take 51 votes (or 50 plus the Vice President to break the tie).

So, this is an extremely strong reason why Democrats should support elimination of the filibuster. Basically, or largely, what they would do would be permanent, like Medicare, unemployment insurance, free public schooling, etc., but the harm the Republicans would do would only be temporary, often quite temporary.

People would relatively quickly see the great harm to everyone except perhaps the rich (and even for them, the extra few thousand square feet of mansion would help them and their families far less than they would be hurt by the decreased public health, safety, medical and scientific investment, and thus advancement, having to walk over homeless people, or live behind walls, etc., etc.)

Thus, the argument that some Democrats make that we should keep the filibuster because it prevents the Republicans from doing great harm, like say eliminating Social Security or Medicare, is more than countered. Republicans would not dare eliminate such popular programs, and even if they did, the very next election they would be decimated at the ballet box (and tremendously weakened and revealed for generations), and the elimination would be quickly reversed. By contrast, the good Democrats would do, like universal healthcare, or perhaps eventually even Medicare for all, would essentially be permanent.

Why do you think the United States has suffered as the only advanced country in the world without universal health care for so long? One answer is the filibuster. Without it we probably would have had universal health care long ago. Ezra Klein of the Washington Post wrote today, "There's a lesson in that, and it's not that we need to oppose 'government-run health-care experiments.'". In the comments I replied:

One of the biggest problems with the filibuster is that it makes it far harder to learn by experimenting, to see first hand if the claims against a program or idea were false (or grossly, ridiculously false). It really hurts the U.S. when other advanced countries are far freer than us to experiment and learn, with their completely Democratic legislatures as opposed to our Senate, where Wyoming gets the same votes as California with about 70 times the citizens, and where with the filibuster on top of that, senators representing only about 10% of the citizens can stop a bill favored by senators representing about 90%.

There are, of course, other important reasons to eliminate the filibuster, a key one being the undemocraticness I mentioned above. The Senate's undemocraticness may be in the original constitution, but so was slavery, so was women not having the right to vote, and senators being appointed by state legislatures rather than being elected. Should we have not changed those things because they were in the original constitution? The founding fathers were extremely intelligent. They knew that the constitution and the original government were not perfect; that's why they designed them so that they could be improved, so they were living, not ossified. The founding fathers also had the character to admit flaws in their country, and to realize that it was patriotic to do so, so those flaws could be fixed. Not being willing to admit flaws and problems with your country, and trying to intimidate those who do, is the opposite of patriotism. It hurts your country and holds it back.

Finally, of course, let us not forget global warming. Do we really want to take the monumental risk of planetary devastation from waiting 30, 50, 100 years until luck, skill, and circumstances are just right that we can get strong anti- global warming legislation past a Republican filibuster?

Update: With regard to the power of learning by doing, the power of actually trying things to see first hand if the claims are true, and if the counter claims, or scare tactics, are false (and the Republicans come up with some outrageous whoppers that unfortunately often work), please see this important post at the Charter Cities blog of acclaimed economist, and likely future Nobel Prize winner, Paul Romer.

Speaking of media abdication...

Nobel Prize winning economist Paul Krugman writes today:

From the Times, January 2008:

First, those who don’t want to nominate Hillary Clinton because they don’t want to return to the nastiness of the 1990s — a sizable group, at least in the punditocracy — are deluding themselves. Any Democrat who makes it to the White House can expect the same treatment: an unending procession of wild charges and fake scandals, dutifully given credence by major media organizations that somehow can’t bring themselves to declare the accusations unequivocally false (at least not on Page 1).

For prime evidence see my last post.

Update: Wow! I'm stunned that the New York Times had a front webpage headline, no less, calling a Republican lie false, "False ‘Death Panel’ Rumor Has Some Familiar Roots". I get so disappointed with the press, that when they stand up and explain important information in an accurate non-misleading way – by stating clearly verifiable Republican lies as false – it stuns me. I like to think my blog post had something to do with it (Ha), but anyway this is great to see.

The article even assigns blame to top mainstream Republicans, like "the party’s last vice-presidential nominee, Sarah Palin, and Charles E. Grassley, the veteran Iowa senator", as well as "many of the same pundits and conservative media outlets that were central in defeating President Bill Clinton’s health care proposals 16 years ago, including the editorial board of The Washington Times, the American Spectator magazine and Betsy McCaughey, whose 1994 health care critique made her a star of the conservative movement (and ultimately, New York’s lieutenant governor)." The blame is truthfully due, but it's great to see this after the press so often not being willing to tell the public when Republican politicians and organizations are responsible for spreading lies, due to caring more about what they think looks "even-handed" than conveying important information to the public in an accurate non-misleading way.

New York Times misleads: outrageous lie "forced euthanasia" refered to as "questionable" charge

A front webpage August 11th New York Times article, begins, "The White House on Monday started a new Web site to fight questionable but potentially damaging charges that President Obama’s proposed overhaul of the nation’s health care system would inevitably lead to “socialized medicine,” “rationed care” and even forced euthanasia for the elderly."

How is, "forced euthanasia for the elderly" a questionable charge, and not a flat-out outrageous lie?

If the Republicans claimed the Earth was flat, I'm not sure how many mainstream journalists would call this false, thinking it wouldn't be "even handed".

The writer does use the words, "inevitably lead to", but that's still just an impossibility for "forced euthanasia for the elderly" that should be obvious to a writer for one of the leading newspapers in the country. There is, of course, nothing in the bill about forced euthanasia, and it is no more possible that this bill could lead to forced euthanasia, than that passing Medicare for seniors in 1965 could lead to "forced euthanasia for the elderly". It should be obvious to a writer for a premier newspaper that for reasons of grave morality as well as political self-destruction this would never happen, unless you want to consider possibilities like a weird space virus coming to Earth and driving everyone insane, in which case the writer should make clear that he means possibilities like this, instead of grossly misleading.

There is also nothing in the bill for socialized medicine; there is no government ownership of the health care system. With regard to "Rationed care", this is fairly subjective. Typical free market health insurance has a lifetime limit of $1 million or less, and often $250,000 or less. This could certainly lead to rationed care for many illnesses, or no care, especially if you have no health insurance, like so many Americans. And HMOs deny many treatments. But there is nothing that explicitly rations health care in Obama's bill. The bill provides for minimums, subsidies, and protections, but no restrictions on what additional insurance and treatments people may buy. All of this should be made clear so as not to grossly mislead the public on a very important issue.

Mainstream journalists, in general, clearly don't consider conveying important information in an accurate, non-misleading way their top priority, or even a very high one relative to its great importance, and the country has paid a momentous price for this.

Problems fixed and improvements made in last post

My last post has been substantially revised and improved. I think now it's pretty complete and well done.