With the recent market turmoil, there has been a lot of talk in the press and even around the water cooler about the nature of risk. Most people seem to understand that investing in the stock market is risky. They also understand that the more risk one takes, the greater the possible upside and downside of the investment. What many don’t seem to understand is what, exactly, is risky about investing in the stock market as well as how risks can be mitigated.
A great book on this subject is A Random Walk Down Wall Street by Burton G. Malkiel. This book details, for example, why a well diversified stock portfolio is less risky than a single stock. Malkiel shows that it takes a minimum of 20 to 30 stocks across a number of asset classes to provide sufficient diversification for a typical investor. For example, if one holds the 30 companies in the Dow Jones Industrial Average, a typical market cycle might have Coca-Cola announce a new product offering which boosts its stock price, while 3M announces layoffs. These types of stock movements are offsetting and are generally the reason why a diversified portfolio is less risky than individual stocks.
A diversified portfolio is still exposed to “systemic” effects on the market — effects that are spread across the whole market. This is most easily observed in the current market turmoil. Clearly it’s not possible for every company to be doing poorly right now — somebody must be making money in a Bear market. But the market average is down, and as a result, many good companies are getting hit hard on their stock prices simply because of the financial crisis.
Another aspect to risk, and the one about which I have been trying to remind my coworkers and friends, is the time factor. When purchasing an investment, one has to be aware of both the time one can afford to tie up money in the investment, as well as the typical time for the investment to achieve the kind of return being sought. This is fairly easy to see with a Certificate of Deposit: you buy a CD that pays a certain percentage yield and that has a limited lifetime of months or years. There are penalties for withdrawing money early. The equation is less well defined when it comes to investments such as houses, stocks, or tulips. The risk with investments such as these (well, not the tulips as much…) is not that the investment won’t hold value or yield a return, but rather over what time period the investment will pay off.
Conventional wisdom suggests investors be prepared for minimum investment times to substantially reduce the chance that the investment will depreciate while held. The purchaser of a house, for example, should be prepared to hold the house for 5 years or longer to have a high degree of certainty that the money invested can be recovered in full. Diversified stock portfolios are more like 10 years of holding time. In fact, (according to Malkiel) there has never been a 10 year period since 1926 in which the stock market has returned a negative yield, and there has never been a 25 year period in which the return was less than 8%.
The point in all of this is that you should not panic about the volatility of the current market. In fact, the less you pay attention to it the better off I expect that you’ll be. If you are investing for retirement and you have ten years or more left to invest, you shouldn’t even sweat during this crisis. If you have less than 20 years until retirement, or are retired already, you should have made and be making annual or semi-annual changes to your portfolio to reduce your risk exposure by locking up your stock gains in less risky vehicles like bonds. This is what’s known as rebalancing your portfolio. If your time horizon for a certain pile of money is shorter than 10 years, then your exposure to the stock market should be minimal.
The absolute worst thing that you can do right about now is to get scared and change the way you are investing because of the market fluctuations. Selling off stock now is the opposite of what everyone knows is the key to investment success: buy low, sell high. Selling now is “selling low” and locks in your losses. I have not lost any money in the current market, and I say this because all my losses are on paper so far. I still own the same number of shares this week as I did last week. Only by selling shares now can I be sure to lose money in this market. History tells us that some of the greatest days in the stock market follow some of the worst, and Monday’s stock market performance is certainly evidence of this. Selling when the market is low takes your money out of play and eliminates any chance of regaining the value lost in your portfolio as the market rebounds.
Are you concerned about the loss of value in your 401k plan? Have you made any changes to stem your losses, or are you just gritting your teeth and bearing it? Do you find yourself checking the value more frequently or less frequently because of the volatility? How much risk can you stomach? I’d like to read your perspective on the situation in the Comments Section below.
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Last month I finished reading a great book called Nudge: Improving Decisions about Health, Wealth, and Happiness by Richard H. Thaler and Cass R. Sunstein. In short, this book was fantastic and I highly recommend it.
The authors indicate early on that they wanted to subtitle the book Libertarian Paternalism but didn’t think anyone would read it if they did. “Libertarian Paternalism?” you may be asking, “isn’t that an oxymoron?” Well, it is and it isn’t. The central point of the book is that we all make choices on a daily basis. Some choices are easy: which breakfast cereal to buy or what to have for dinner. Some choices are hard: Who to marry or what house to buy or how much to save for retirement. The authors argue that more choices are always better than fewer (libertarianism), but that most of us don’t have the information, context, or practice in making some of the hardest choices and that it would be great if there was some way to “nudge” us in the right direction (paternalism).
A classic “nudge” exists thanks to recent laws regarding how employers can handle 401(k) and other retirement benefits plans. Employers can now automatically enroll new employees in the company 401(k) plan when they start. So a new employee would, from paycheck #1 on, see a 5% contribution to a moderate blended fund in the 401(k) plan of the company. At any time, the employee can march down to the Human Resources office and change the contribution or allocation or discontinue it altogether. However, research has shown that inertia is a powerful factor that works equally well in keeping people in the plan as it does keeping them out when no such automatic enrollment is used.
Another great “nudge” was a recent law in New York City that requires restaurants to post their board of health ratings in the front window. No change was made to the board of health standards, but almost overnight the average restaurant health rating rose substantially. After all, who wants to eat in a restaurant with a D- posted in the front window? As a result, NYC emergency rooms have seen a marked decline in food borne illness cases. NYC could have had the same outcome by instituting more stringent restaurant hygiene laws and consequently increasing the time and money it would take to enforce those laws, but this solution avoids additional government intervention AND achieves the same outcome. Plus, restaurants still have the choice of whether to clean up or not, but the “nudge” comes from their lack of business rather than a government edict.
Let’s face it, modern life is complicated, and we don’t have to look far to see the results of ordinary people making poor choices on really important things like mortgages, health care, etc. Nudge argues that we get better at making good choices the more we practice (just like anything else). We get lots of practice making choices about things that have relatively low consequences. If you choose the wrong cereal, you’re out $4 or a week of dissatisfaction for 10 minutes every morning. But most of us only purchase a few houses in our lifetimes, and the consequences for choosing poorly can be disasterous. Just look at the current bankruptcy and foreclosure crises to be sure.
So how do we start “nudging”? It starts with any person or organization who has the responsibility of presenting a list of options to someone else. The book provides proof that just by the way choices are arranged in a list that the “choice architect” influences the outcome of the choice (this ranges from lunchrooms to polls). All “choice architects” are going to influence the outcome of the choice, so they have a social responsibility to structure the choices in such a way so that most people will make the best choice if they know nothing else. If possible, even, a default option should be available so that if a person makes no choice something will automatically happen.
The book cites the recent change in the Medicare Prescription drug benefit program as an example of how not to nudge. People eligible for this program who made no selection from among the 43 separate plans available were randomly assigned to a plan. The authors argue that at the very least a patient’s prescription history could have been surveyed to come up with a plan close to what they need, but this was not done. Additionally, the tools for figuring out which plan was ideal for any given person were severely lacking and often contradictory. While libertarianism was observed here, paternalism was not, and there are currently many people on drug plans that cost them too much or don’t deliver enough or the proper benefits.
One of the final recommendations in the book is for the development of “asymetric paternalism” in choice architecture. The authors argue that “sophisticated” choosers should be free to make a well informed decision that best suits them and that “unsophisticated” choosers should have as much paternalistic intervention as necessary. I agree, however what’s not clear to me is how one defines and sorts out the sophisticated from the non. I remember trying to argue my way out of a mandatory youth group ski class because I had been skiing once before (and was, therefore, an expert!). After the instructor pointed out that my ski boots weren’t buckled even though I was clicked into my bindings, I shut my mouth and took the class. (Today I enjoy taking advanced level classes…) The point is that most of us think we are sophisticated when we are not, so the choice architect has to be very careful when he applies his nudge…
The book defines the Jekyll and Hyde nature of the choosers within all of us. The “Human” is akin to the Homer Simpson in all of us who has absolutely no impulse control and makes choices without thinking. The “Econ” is akin to Mr. Spock of Star Trek fame who was always absolutely logical in making decisions. The planning Econ in all of us makes great decisions on paper (by making a shopping list) but the Human comes home with donuts anyway (Mmm… donuts…). Nudge offers us a new set of “tricks” for making difficult decisions easier. It’s a great read and probably available at your local library.
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