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

[Norman]

I think treasuries are mispriced because of FED's and other central banks' actions - who don't care about profits but politics and the like. That means you can kind of throw investment theory in the water. And that's why treasuries can be at times a terrible investment. (Yes you can actually benefit from their actions as well in the short run).

But I really think the OP should decide whether he wants to talk about the superiority of government bonds vs. stocks in general, or social security retirement plans. Because those are different discussions.

 

[Connery]

Moved to proper forum

 

[OohPooPahDoo]

So I would have volunteered to have future benefits cut by an amount greater than the exemption I was getting..

Unless you can predict the day you will die its kinda hard to tell whether you will net or lose cash on social security

OR --- why shouldn't the "premiums" include a 2% kicker ABOVE expected payment liabilities to build up a REAL investment fund? 2% would move the SS FICA from about 12.2% to 12.5%. Trivial amount per paycheck.. Brings in a 4 or 5 $BILL/yr to invest..

That's how real people invest for their future..

So "real people" don't buy U.S. Treasuries? Its actually considered - almost universally - the safest dollar denominated asset.


OK.


If you put SS tax revenues into stock all you're doing is artificially inflating stock prices. When the demographics change and there are more SS retirees drawing on that investment than workers contributing - it will cause stock prices to artificially decline. Either way its not going to affect the total amount of economic resources available in the future. The economy will need to produce most of the goods and services that retirees need to live close to the time they actually need those goods and services - there's nothing that can be done to avoid that.

 

[OohPooPahDoo]

I think treasuries are mispriced because of FED's and other central banks' actions - who don't care about profits but politics and the like. That means you can kind of throw investment theory in the water. And that's why treasuries can be at times a terrible investment. (Yes you can actually benefit from their actions as well in the short run).

But I really think the OP should decide whether he wants to talk about the superiority of government bonds vs. stocks in general, or social security retirement plans. Because those are different discussions.

Are you suggesting that instead of stocks being under priced - treasuries are over-priced?


I've sometimes wondered if that's really the case. Treasuries are subject to more artificial buying and selling pressure than stocks, so it stands to reason they could be mis-priced.

 

[CrusaderFrank]

Just to revisit, the SS "Trust Fund" "Invests" in a special issuance of "Bonds" that can only be sold back to the US Government.

With me so far?

These are "Assets" that only have value if the Government can borrow from someplace else to redeem them

Still there?

Do you see the problem here?

 

[OohPooPahDoo]

There are arbitrageurs who take advantage of that.

Your thinking is backwards. If there is a bet with 10 to 1 odds and I'm demanding to pay only $0.90 for a $10 potential payout - an arbitrageur can't take advantage of that. No one can except the risk seeking.

The implied volatility of options is generally higher than realized volatility.

Under the assumption that the realized path the stock price takes is a log-normal distribution, that is generally (though not always), true, yes - but real stock prices don't exactly follow the log-normal distribution. The real distribution has slightly fatter tales, and if you compute the volatility of a stock based on its option prices and the assumption of a log-normal distribution - those fatter tails show up as the volatility smile.

In other words, the distribution assumed for the real price is not the same as the distribution the option chain is implying, meaning any comparisons of volatility between the two won't be exactly apples and apples.

The arbitrageurs write options and collect the premium, then hedge the underlying.

Yes, but they won't be able to make money writing options if you are only willing to to pay less than the expected payout of of the option (risk-averse).

 

[OohPooPahDoo]

Its worth thinking about these things and doing a little research into risk-neutrality and arbitrage free pricing before mindlessly repeating again "economic theory says...."

Like I said, take it up with every university in the world that teaches finance and economics because that is what they teach.

What is it that they teach exactly?

 

[OohPooPahDoo]

Yes, your political representatives that you voted for and supported, were acting on your behalf at your request, to pilfer their money and spend it on entitlement. Now the money is gone, and you think it should be MY responsibility to pay it back?

You don't even know what you're talking about. What are you, 12 years old?

 

[OohPooPahDoo]

Risk neutrality is used in options theory to price options. It's an assumption to make options pricing mathematically easier.

Risk-neutrality is a result of efficient markets. As I pointed out earlier - for an options trader to demand a discount for risk (risk-averse) the guy on the other side of the trade has to be willing to pay extra for risk (risk-seeking). It can't happen any other way.

It doesn't mean that all financial markets are risk neutral. It assumes that the expected return on stocks is the risk-free rate. Modern portfolio theory says otherwise.

The "expected return" isn't something that MPT predicts - its a parameter that MPT requires.

 

[OohPooPahDoo]

So I decided to revisit risk neutrality. Here is what it says in Introduction to Futures and Options Markets, Second Edition, by John C Hull, page 270.

Note that risk-neutral valuation does not state that investors are risk neutral. What it does state is that derivative securities such as options can be valued on the assumption that investors are risk neutral.

IOW, risk neutrality is used to price options, not to make a general statements about the behavior of financial market participants.

It doesn't state that human investors are risk-anything. (Finance tries to avoid actual biology as much as possible) However - the market operates in a way that makes it appear the players are - on average - risk neutral.

The expected return on all stocks in a risk-neutral world is the risk-free rate.

Clearly, MPT says otherwise, as demonstrated in CAPM where stocks are a function of volatility and the expected return of the market above the risk-free rate.

MPT doesn't say anything about what the correct expected return of the market overall is - as I've pointed out - this is a parameter required by MPT, not a parameter that MPT computes.



To put the absurdity of relying on past returns to predict future returns, take a look at SPY returns for the past year:

SPDR S&P 500 ETF Chart - Yahoo! Finance



If you look at it, you'll see lots of ups and down - but the clear overall trend is upward. The total increase is a little over 20%. There is a period of decline - during the fall of 2012 - but the prices recover and the market is again at pre-decline levels by February.

So based on this evidence, we should be able to conclude that although the price of the S&P 500 goes up and down, over any period that is at least 6 months long, it will at least retain its value, and on average, it will return 20%. Although we're only looking at one year of data - we can stagger 6 month samples so that we have as many samples as we like - and we could make a nice chart that shows the odds of winning or losing X dollars over certain intervals - and using all that, we should be able to convince people, like yourself, that the S&P 500 will always retain its value over 6 month periods.


Now do you see how absurd it is to base your expected 30 year return on barely more than 3X30 years of data? That's only 50% better than basing your expected 6 month return on a years worth of data, is it?

In fact if you look at the stock chart from a single day of a stock that did well on that day, you might conclude - using your method of reasoning - that the stock will go up and down but always retain or beat its value over 1 hour periods.

 

[OohPooPahDoo]

Just to revisit, the SS "Trust Fund" "Invests" in a special issuance of "Bonds" that can only be sold back to the US Government.

With me so far?

These are "Assets" that only have value if the Government can borrow from someplace else to redeem them

Still there?

Do you see the problem here?

They are just as valuable as any Treasury. If the government decided to default on a trust fund IOU it would be perceived by investors in other treasury instruments as a default on all the government's obligations, and ordinary T-bills,bonds,and notes would crash as well. Its all the same credit.

Do you have a bank account? There's a good chance a substantial portion of your deposit is investing in short term treasuries. You'd better go withdraw your money now!

 

[Toro]

Its worth thinking about these things and doing a little research into risk-neutrality and arbitrage free pricing before mindlessly repeating again "economic theory says...."

Like I said, take it up with every university in the world that teaches finance and economics because that is what they teach.

What is it that they teach exactly?

That investors are not risk neutral, that they have to be compensated for taking risks.

 

[Toro]

Risk neutrality is used in options theory to price options. It's an assumption to make options pricing mathematically easier.

Risk-neutrality is a result of efficient markets. As I pointed out earlier - for an options trader to demand a discount for risk (risk-averse) the guy on the other side of the trade has to be willing to pay extra for risk (risk-seeking). It can't happen any other way.

It doesn't mean that all financial markets are risk neutral. It assumes that the expected return on stocks is the risk-free rate. Modern portfolio theory says otherwise.

The "expected return" isn't something that MPT predicts - its a parameter that MPT requires.

MPT states that investors must be compensated for risk. The higher the risk investors take, the more they must be compensated. Otherwise, there is no reason to take risk.

Risk isn't symmetric. People will pay a higher price to avoid losses. This can skew pricing, and may explain why the equity risk premium is too high, why people overpay for protection in options markets, why futures markets are in backwardation, why there is a term premium in bond markets, and why people buy warranties for their iPad.

 

[Toro]

Just to revisit, the SS "Trust Fund" "Invests" in a special issuance of "Bonds" that can only be sold back to the US Government.

With me so far?

These are "Assets" that only have value if the Government can borrow from someplace else to redeem them

Still there?

Do you see the problem here?

They are just as valuable as any Treasury. If the government decided to default on a trust fund IOU it would be perceived by investors in other treasury instruments as a default on all the government's obligations, and ordinary T-bills,bonds,and notes would crash as well. Its all the same credit.

Do you have a bank account? There's a good chance a substantial portion of your deposit is investing in short term treasuries. You'd better go withdraw your money now!

I don't think the SS trust liabilities are as valuable as Treasuries. People don't understand the SS liabilities. If the US defaulted on Treasuries, it would create shock waves throughout global markets. If the government cut SS benefits, risk assets would probably rise.

I do agree though that they are real. The trusts mimic a bond fund without the bonds.

 

[Toro]

So I decided to revisit risk neutrality. Here is what it says in Introduction to Futures and Options Markets, Second Edition, by John C Hull, page 270.

Note that risk-neutral valuation does not state that investors are risk neutral. What it does state is that derivative securities such as options can be valued on the assumption that investors are risk neutral.

IOW, risk neutrality is used to price options, not to make a general statements about the behavior of financial market participants.

It doesn't state that human investors are risk-anything. (Finance tries to avoid actual biology as much as possible) However - the market operates in a way that makes it appear the players are - on average - risk neutral.

The expected return on all stocks in a risk-neutral world is the risk-free rate.

Clearly, MPT says otherwise, as demonstrated in CAPM where stocks are a function of volatility and the expected return of the market above the risk-free rate.

MPT doesn't say anything about what the correct expected return of the market overall is - as I've pointed out - this is a parameter required by MPT, not a parameter that MPT computes.



To put the absurdity of relying on past returns to predict future returns, take a look at SPY returns for the past year:

SPDR S&P 500 ETF Chart - Yahoo! Finance



If you look at it, you'll see lots of ups and down - but the clear overall trend is upward. The total increase is a little over 20%. There is a period of decline - during the fall of 2012 - but the prices recover and the market is again at pre-decline levels by February.

So based on this evidence, we should be able to conclude that although the price of the S&P 500 goes up and down, over any period that is at least 6 months long, it will at least retain its value, and on average, it will return 20%. Although we're only looking at one year of data - we can stagger 6 month samples so that we have as many samples as we like - and we could make a nice chart that shows the odds of winning or losing X dollars over certain intervals - and using all that, we should be able to convince people, like yourself, that the S&P 500 will always retain its value over 6 month periods.


Now do you see how absurd it is to base your expected 30 year return on barely more than 3X30 years of data? That's only 50% better than basing your expected 6 month return on a years worth of data, is it?

In fact if you look at the stock chart from a single day of a stock that did well on that day, you might conclude - using your method of reasoning - that the stock will go up and down but always retain or beat its value over 1 hour periods.

That's like saying "How do we know Western society works? We only have 200 years of data?" Perhaps we should crawl through the wormhole and measure the infinite multiverses, then we will have enough statistical data to see if the foundations of Western society are real.

If financial markets operate as if they are risk neutral, then why aren't the average returns the risk-free rate?

As for the past predicting the future, I do not believe that markets are efficient all the time, but I do believe they are efficient over long periods of time. In an efficient market, higher risk assets should earn more than lower risk assets over long periods of time. That's what theory says and that's what has happened in the past. Both theory and history tell us that those with long time frames are compensated for taking on risk. Thus, we should invest SS in the stock market like other pension funds and insurance companies, as do other national retirement schemes like in Europe and Canada.

 

[flacaltenn]

Just to revisit, the SS "Trust Fund" "Invests" in a special issuance of "Bonds" that can only be sold back to the US Government.

With me so far?

These are "Assets" that only have value if the Government can borrow from someplace else to redeem them

Still there?

Do you see the problem here?

They are just as valuable as any Treasury. If the government decided to default on a trust fund IOU it would be perceived by investors in other treasury instruments as a default on all the government's obligations, and ordinary T-bills,bonds,and notes would crash as well. Its all the same credit.

Do you have a bank account? There's a good chance a substantial portion of your deposit is investing in short term treasuries. You'd better go withdraw your money now!

I don't think the SS trust liabilities are as valuable as Treasuries. People don't understand the SS liabilities. If the US defaulted on Treasuries, it would create shock waves throughout global markets. If the government cut SS benefits, risk assets would probably rise.

I do agree though that they are real. The trusts mimic a bond fund without the bonds.

Even the SSA annuals and the CBO state that shortfalls come out of current taxes. And they must be covered by raising revenue, issuing NEW debt, or changing the terms of the program.. It's a cynical ruse..

Try THAT on a bond fund (with or without the bonds)..

And there's the prob for OopyDoos analysis of SSA trust fund being "default proof".. Default HERE --- includes changing the payouts.. Or the ROI for various classes of investors. And THAT is more likely to happen BEFORE a classic default is considered.

 

[OohPooPahDoo]

Like I said, take it up with every university in the world that teaches finance and economics because that is what they teach.

What is it that they teach exactly?

That investors are not risk neutral, that they have to be compensated for taking risks.

But compensated by whom?

 

[OohPooPahDoo]

Just to revisit, the SS "Trust Fund" "Invests" in a special issuance of "Bonds" that can only be sold back to the US Government.

With me so far?

These are "Assets" that only have value if the Government can borrow from someplace else to redeem them

Still there?

Do you see the problem here?

They are just as valuable as any Treasury. If the government decided to default on a trust fund IOU it would be perceived by investors in other treasury instruments as a default on all the government's obligations, and ordinary T-bills,bonds,and notes would crash as well. Its all the same credit.

Do you have a bank account? There's a good chance a substantial portion of your deposit is investing in short term treasuries. You'd better go withdraw your money now!

I don't think the SS trust liabilities are as valuable as Treasuries. People don't understand the SS liabilities. If the US defaulted on Treasuries, it would create shock waves throughout global markets. If the government cut SS benefits, risk assets would probably rise.

I do agree though that they are real. The trusts mimic a bond fund without the bonds.

SS benefits are not directly tied to the trust fund securities. The government could cut benefits while still paying its obligations in the SS trust fund.

 

[OohPooPahDoo]

So I decided to revisit risk neutrality. Here is what it says in Introduction to Futures and Options Markets, Second Edition, by John C Hull, page 270.



IOW, risk neutrality is used to price options, not to make a general statements about the behavior of financial market participants.

It doesn't state that human investors are risk-anything. (Finance tries to avoid actual biology as much as possible) However - the market operates in a way that makes it appear the players are - on average - risk neutral.

Clearly, MPT says otherwise, as demonstrated in CAPM where stocks are a function of volatility and the expected return of the market above the risk-free rate.

MPT doesn't say anything about what the correct expected return of the market overall is - as I've pointed out - this is a parameter required by MPT, not a parameter that MPT computes.



To put the absurdity of relying on past returns to predict future returns, take a look at SPY returns for the past year:

SPDR S&P 500 ETF Chart - Yahoo! Finance



If you look at it, you'll see lots of ups and down - but the clear overall trend is upward. The total increase is a little over 20%. There is a period of decline - during the fall of 2012 - but the prices recover and the market is again at pre-decline levels by February.

So based on this evidence, we should be able to conclude that although the price of the S&P 500 goes up and down, over any period that is at least 6 months long, it will at least retain its value, and on average, it will return 20%. Although we're only looking at one year of data - we can stagger 6 month samples so that we have as many samples as we like - and we could make a nice chart that shows the odds of winning or losing X dollars over certain intervals - and using all that, we should be able to convince people, like yourself, that the S&P 500 will always retain its value over 6 month periods.


Now do you see how absurd it is to base your expected 30 year return on barely more than 3X30 years of data? That's only 50% better than basing your expected 6 month return on a years worth of data, is it?

In fact if you look at the stock chart from a single day of a stock that did well on that day, you might conclude - using your method of reasoning - that the stock will go up and down but always retain or beat its value over 1 hour periods.

That's like saying "How do we know Western society works? We only have 200 years of data?" Perhaps we should crawl through the wormhole and measure the infinite multiverses, then we will have enough statistical data to see if the foundations of Western society are real.

If financial markets operate as if they are risk neutral, then why aren't the average returns the risk-free rate?

As for the past predicting the future, I do not believe that markets are efficient all the time, but I do believe they are efficient over long periods of time. In an efficient market, higher risk assets should earn more than lower risk assets over long periods of time. That's what theory says and that's what has happened in the past. Both theory and history tell us that those with long time frames are compensated for taking on risk. Thus, we should invest SS in the stock market like other pension funds and insurance companies, as do other national retirement schemes like in Europe and Canada.

The past 1 year of history has shown that 6 month periods the S&P 500 doesn't lose value. Do you dispute this claim?

 

[Toro]

What is it that they teach exactly?

That investors are not risk neutral, that they have to be compensated for taking risks.

Compensated by whom?

By the growth in the economy.