"What Stock to Buy? Hey, Mom, Don’t Ask Me" Economist Answers.
OVER the last few weeks, as the stock market has reached new
highs, my thoughts have turned to my 85-year-old mother.
“O.K. Mr. Smarty-Pants,” she often asks me, “what stock should I
buy now?”
She first asked me this question when I was an undergraduate at
Princeton, majoring in economics. She asked again when I was a
graduate student at M.I.T., earning a Ph.D. in economics. And she
has asked it regularly during the last three decades when I have
been an economics professor at Harvard.
Unfortunately, she has never been happy with my answers, which are
usually evasive. Nothing in the toolbox of economists makes us
good stock pickers.
Yet we economists have written countless studies about the stock
market. Here is a summary of what we know:
THE MARKET PROCESSES INFORMATION QUICKLY One prominent theory of
the stock market — the efficient markets hypothesis — explains how
answering my mother’s question would be a fool’s errand. If I knew
anything good about a company, that news would be incorporated
into the stock’s price before I had the chance to act on it.
Unless you have extraordinary insight or inside information, you
should presume that no stock is a better buy than any other.
This theory gained public attention in 1973 with the publication
of “A Random Walk Down Wall Street,” by Burton G. Malkiel, the
Princeton economist. He suggested that so-called expert money
managers weren’t worth their cost and recommended that investors
buy low-cost index funds. Most economists I know follow this
advice.
PRICE MOVES ARE OFTEN INEXPLICABLE Even if changes in stock prices
are unpredictable, as efficient markets theory suggests, we should
be able to explain these changes after the fact. That is, we
should be able to identify the news that causes stock prices to
rise and fall. Sometimes we can, but often we can’t.
In 1981, Robert J. Shiller, a regular contributor to this column
and an economics professor at Yale, published a paper in The
American Economic Review called, “Do Stock Prices Move Too Much to
Be Justified by Subsequent Changes in Dividends?” He argued that
stock prices were too volatile. In particular, they fluctuated
much more than a rational valuation of the underlying fundamentals
would.
Mr. Shiller’s paper prompted a storm of controversy. My reading of
the subsequent academic literature is that his conclusions, though
not all his techniques, have survived the debate. Stock prices
seem to have a life of their own.
Advocates of market rationality now say that stock prices move in
response to changing risk premiums, though they can’t explain why
risk premiums move as they do. Others suggest that the market
moves in response to irrational waves of optimism and pessimism,
what John Maynard Keynes called the “animal spirits” of investors.
Either approach is really just an admission of economists’
ignorance about what moves the market.
HOLDING STOCKS IS A GOOD BET The large, often inexplicable
movements in stock prices might deter someone from holding stocks
in the first place. Many Americans, even some with significant
financial assets, avoid stocks altogether. But doing so is a
mistake, because the risk of holding stocks is amply rewarded.
In 1985, Rajnish Mehra and Edward C. Prescott, both now at Arizona
State University, published a paper in the Journal of Monetary
Economics called “The Equity Premium: A Puzzle.” They pointed out
that over a long time span, stocks have earned, on average, about
6 percent more per year than safe assets like Treasury bills. This
large premium, they said, is hard to explain with standard
economic models. Sure, stocks are risky, so you can never be
certain you’ll earn the premium, but they are not risky enough to
justify such a large expected return.
Since the paper was published, economists have made some limited
progress in explaining the equity premium. In any event, the large
premium has convinced most of us that stocks should be part of
everyone’s financial plan. I allocate 60 percent of my financial
assets to equities.
Stocks may be an especially good deal today. According to a recent
study by two economists at the Federal Reserve Bank of New York,
given the low level of interest rates, the equity premium now is
the highest it has been in 50 years.
DIVERSIFICATION IS ESSENTIAL Every time a company experiences a
catastrophic decline — consider Enron or Lehman Brothers — reports
emerge about employees who held most of their wealth in company
stock. These stories leave economists slapping their heads. If
there is one thing we know for sure, it is that sensible financial
management requires diversification.
So, if you have more than 5 percent of your assets in any one
company, call your broker and sell. Doing otherwise means exposing
yourself to extra risk without extra reward.
SMART INVESTORS THINK GLOBALLY One widely documented failure of
diversification is what economists call home bias. People tend to
invest disproportionately in their home country.
Most economists take a more global perspective. The United States
represents a bit under half of the world’s stock portfolio.
Because Europe, Japan and the emerging markets don’t move in lock
step with the United States, it makes sense to invest abroad as
well.
Which brings me back to my mother’s question: If I could pick just
one stock for someone to buy, what would it be? I would now
suggest something like the Vanguard Total World Stock
exchange-traded fund, which started trading in 2008. In one
package, you can get low cost and maximal diversification. It may
not be as exciting as trying to pick the next Apple or Google, but
you’ll sleep better at night.
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