Friday, April 6, 2012

Some finance readings

I’ve been trying to wrap my head around some finance related papers and wondering if academic economists have anything useful to say to the average investor, myself included.

The papers are:
1. Jagannathan and Kocherlakota: Why should older people invest less in stock than younger people?
2. Cochrane (1999): New Facts in Finance
3. Cochrane (1999): Portfolio Advice in a Multifactor World

The Jagannathan and Kocherlakota paper seemed to suggest that older people shouldn’t invest less in stocks. They evaluate several claims and conclude (this is from the abstract):

Financial planners typically advise people to shift investments away from stocks and toward bonds as they age. The planners commonly justify this advice in three ways. They argue that stocks are less risky over a young person’s long investment horizon, that stocks are often necessary for young people to meet large financial obligations (like college tuition for their children), and that younger people have more years of labor income ahead with which to recover from the potential losses associated with stock ownership. This article uses economic reasoning to evaluate these three different justifications. It finds that the first two arguments do not make economic sense. The last argument is valid—but only for people with labor income that is relatively uncorrelated with stock returns. If a person’s labor income is highly correlated with stock returns, then that investor is better off shifting investments toward stocks over time.

But then almost everyone’s income is uncorrelated with the stock market - except those who are working on Wall Street (or with income tied to the stock market).

The first of Cochrane’s paper summarizes some findings in empirical finance regarding book-to-market ratios (Fama-French factors), momentum investing, forward premium bias and other violations of the CAPM model. This was all good stuff and it was a good review that I needed to get up to speed. In the second paper however, he says that after taking all these multiple factors into consideration, the average investor should hold the market and by this he means the following:

An investor should hold, in addition to the market portfolio and risk-free bonds, a number of passively managed “style” funds that capture the broad (nondiversifiable) risks common to large numbers of investors. In addition to the overall level of risk aversion, his exposure to or aversion to the various additional risk factors matters as well.
...
I emphasize a cautionary fact: The average investor must hold the market. You should only vary from a passive market index if you are different from everyone else.

Unfortunately despite the fact that I retained very little from my finance classes, the takeaway that I got from them was that there is very little consensus on what constitutes the passive market portfolio. What is the percentage of bonds (T-bills or something else), or other passive style funds? How much does real estate weigh into this?

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