Why investing SS in the stock market is a horrible idea.

[Toro]

What is "etc." ?

That's the trouble with the diversification myth. Its usually stated as "diversification means stocks, bonds, real estate, etc." and there is no explanation of the etc. First of - stocks and real estate together aren't really that diverse, as the past economic collapse should show you. In fact, if you can find any point in time when the stock market crashed and real estate values remained the same or went up - or vice versa - I'd love to read about it (not saying such a time never existed, just that it would be surprising). Second off - the phrase use to be "stocks, bonds, etc" - then real estate got popular - then it became "stocks, bonds, real estate, etc". Diversification really means "stocks, bonds, whatever is popular to invest in, etc".

I said "etc." because I was being lazy.

The etc. is a variety of not only assets but also risk premia and strategies. Assets include currencies, commodities, infrastructure, land, royalties, timber, foreign bonds, foreign stocks, and so on. Risk premia include carry, small cap and value stocks in equities, and so on. Strategies include divergent strategies such as managed futures. In 2008, the S&P 500 fell 38%. The Barclay's Agg rose 5%. Gold rose 5%. The Barclay Hedge CTA index rose 18%. Many risk parity strategies were down 5% or 10% in 2008.

Diversification moves one out on the efficient frontier. It is a free lunch in finance.

Another huge problem with the diversification myth is the idea that simply having varied assets protects you from loss while haven't non-varied assets exposes you to loss. This isn't the case. Take two portfolios:

Portfolio A)

Equal amounts of exposure to:

S&P 500
corn futures
bit coins
debt of the Mexican government
a worldwide small cap mutual fund
U.S. Treasuries


Portfolio B)

1) long position on Microsoft
2) a put option to sell Microsoft at 90% of what I bought it for


Now which portfolio is more diverse? Clearly Portfolio A! Which is safer from loss? Clearly, Portfolio B!

Portfolio B is a cash replicant. There is empirical research on this. Buying stocks and buying puts on those stocks generates a cash return. Actually, that's not true. It generates a slightly lower return than cash as put buyers tend to over-estimate risk.

So I would say Portfolio A is a better portfolio because it will likely generate a higher return for a commensurate amount of risk over time.

Business can continue to be profitable and at the same time the market might misjudge how profitable they will be. If it turns out Company A is 10X less profitable than the investors thought it would be, Company A is still profitable but its stock will probably drop about 10 fold unless investors think it will make a big turn around. Once the price drops, the P/E ratio becomes more sensible again and the company would appear to be "profitable" to a new investor.

I agree with that. That is why I said I don't always recommend people own stocks. Sometimes, stocks are very expensive and shouldn't be owned. However, over very long periods of time, 50 or 100 years, valuation levels become less important.

I've spent 20 years in capital markets. One of the lessons I tell new people is that in the short run, valuation doesn't matter. The only thing that matters in the short-run is sentiment. In the short-run, and even the intermediate-run, financial markets may not be efficient. In the long-run, however, they are. In the long-run, the only thing that matters is valuation.

I admit I'm still befuddled as to how a gain can "accrue to an asset" and actually be realized without someone having to pay money for it. I know you don't actually believe this - but from your statements thus far it would appear that you are trying to say that businesses just accrue gains without anyone actually having to pay for them - like there's some sort of accrual gremlins that come out when everyone is asleep, dropping risk premiums into the pockets of investors.

I may be wrong but it appears that you are concerned about how the returns are distributed intra-asset class, i.e. between stocks and bonds, as well as the prices paid of those securities. As I said above, I'm not entirely sure why there are risk premia, though I believe it has to do with uncertainty and cognitive biases that cannot be measured by the limited tools of statistics. Markets are raw human emotions at times, which leads to things that cannot be explained by rational behavior, i.e. the persistence of momentum and serial correlation of prices, and thus are not explainable by economists in today's intellectual framework.

 

[Toro]

Of course, one can take this logic from equities to all other asset classes. How do we know bonds will not lose all value in the future?

We don't. Nothing I've said implies otherwise and recent history certainly shows us its a possibility. Are you saying bonds are unfairly priced given the risk of default?

How about real estate falling by 60%?

How about it?


We don't. I don't see how this means we should give a big taxpayer handout to current holders of stock.

How do we know the US is even going to exist 100 years from now?

We don't.

I'm not sure what your argument is. We don't know whether other things will happen in the future, thus we should proceed as if we know for a fact the stock market will return at least X over Y years all the time?

If we take the "The past can't predict the future" argument to its logical extreme, we have no idea about anything in the future and thus we shouldn't even have SS.

No offense, but to emphasize, I would hardly consider rejecting your argument that 3 non-overlapping samples are sufficient to predict future samples to be taking anything to the extreme.

Your argument appears to be that we don't know what the future will be, and we don't have enough statistically significant observations to make conclusions with confidence, therefore, we shouldn't invest SS proceeds in stocks because we have no idea that they will do well in the future. If I'm wrong, let me know.

If I'm not, then I'd turn that argument back to you. Currently, SS is funded by taxpayers. If the future is unknowable, how do we know that taxpayers will continue to fund payments in the future? Stocks have done well over at least 140 years. We've had social security for 80 years. It was revised 45 years ago, and the current iteration was revised 30 years ago. If we can't base conclusions on 140 years of data, how can we base conclusions on 80/45/30 years worth of data? If the future is unknowable for stocks, why is it more knowable for politics? And if we conclude that because the future is unknowable, why do we have SS in the first place given that we have no confidence that payments will be made in the future?

 

[OohPooPahDoo]

This is what CAPM is built upon, which derives from modern portfolio theory, which won the Nobel Prize in economics.

No it didn't.

It won the:

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990

,,, like you said. That's not the Nobel Prize. Its the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Same Alfred Nobel. Different prizes. One comes from his will. One from a bank that likes his name.