Sunday, December 30, 2012

Can Individual Investors Beat the Pros?

            Individual investors clearly do not have the resources to match the trading expertise of sophisticated institutions and hedge funds.  Nor do they have access to the automated trading systems that continually scan the markets and trade in time frames approaching microseconds.  It is not surprising, therefore, that many individual investors, and many pundits as well, have concluded that the best course of action for individuals is to put money into one of the sophisticated funds or go home. In their view, it is no longer possible for individuals to compete effectively in the modern market place.
Such views, though intuitively appealing, turn out to be 180 degrees wrong.  If individual investors accept their limitations and act wisely, they will always outperform active professional investors in the aggregate!  Furthermore, this surprising conclusion does not depend on complex economic arguments regarding market efficiency or market rationality.  Nobel Prize winner William Sharpe has shown that it is a direct result of basic arithmetic.  A simple example illustrates how it works.
            Take all stock market investors and divide them into two groups – passive and active.  The passive group is composed of individual investors who conclude that they do not possess the information nor the skills to compete with active professional investors.  These passive investors buy an index fund designed to match movements in the market as a whole.  Such funds are available at very low cost because no active management is required.  The active group consists of everyone else, but is composed primarily of active professional investors. 
            Now suppose in any given year the market rises by say, 10%.  The index fund, by construction, matches the market so passive individual investors earn 10%.  But if the market goes up 10%, and the passive group earns 10%, the active group must also earn 10% because the market consists of active and passive investors.  For the active investors, however, this 10% is before expenses.  Active investing is expensive whether it is due to designing and implementing costly computers systems or hiring sophisticated traders and analysts (remember they get paid millions).  When these expenses are netted out, the active group as a whole must earn less than 10%.  In other words, the “professionals” as a group must always underperform passive individual investors as a group.  This is true whether the market rises or falls and whether the market is responding rationally or emotionally.  The passive group, as a group, must always outperform the active group, after expenses.
            It should be stressed that the foregoing conclusion holds on a group-wide basis.  Within the group of active investors, some will most likely have done much better than 10% and others much worse.  But as a group, after expenses, they must have earned less than 10%. 
            What Professor Sharpe’s analysis makes clear is that the real threat to the individual investor is not being in the market, it is actively playing the market.  Small investors who passively hold the market can be assured that they will outperform active investors overall.  However, should they decide to become active themselves, all bets are off.

Saturday, December 29, 2012

Promises, Promises - Again

              GregMankiw has a wonderful article in the New York Times today in which he pays homage to the laws of arithmetic.  Those laws say that you cannot forever spend more than you collect in taxes.  Neither party, as Mankiw notes, has taken proper account of those laws.  If we want entitlements of the size currently promised, given the aging of the population and the advances in medical science and life expectancy, taxes will have to go up.  A lot.  On everybody.  Unless, of course, we can repeal the laws of arithmetic.

Friday, December 28, 2012

Hope I Die Before I Get Old

            It has been almost 50 years since Peter Townsend wrote those famous words to the rock song, My Generation.  Over that time, the baby boom generation to which he was referring, got old.  What is more, if government policies regarding the elderly, a group I joined on November 20, 2012, don’t change promptly younger generations may be singing “I hope they die before I go broke.”      

            To appreciate the problem, imagine a thought experiment in which a miraculous genetic breakthrough instantaneously increases the healthy life span to 200 years but retirement still occurs at 65.  Such a breakthrough would produce widespread poverty because the small fraction of working people would have to fund 135-year retirements.  Income per capita eventually would fall by more than half as the non-working population was swamped by the unproductive majority.

            Of course, the actual increase in life expectancy is much less dramatic than the thought experiment.  It has also occurred more slowly over time.  The slow, but consistent, improvement has led policy makers to behave somewhat like the frog in the stove pot when the heat is slowly turned up.  Whereas the frog would immediately jump out if dumped into a boiling pot, if the temperature rises slowly the frog is cooked.         

            Social Security is an example of what is cooking now.  The Social Security Act was signed in August 1935.  At that time, the average life expectancy of Americans was 61 years and approximately 6% of the population was over 65.  By the end of 2012, average life expectancy had risen to 79 years and the percentage of the population over 65 had more than doubled to 15%.  Even more dramatic has been the decline in the number of active private sector employees per social security recipient.  In 1965, when Peter Townsend penned his famous words, there were 4.9 workers for every recipient.  By 2011, the ratio was down to 1.75 and was projected to fall further.  

            A solution both in the case of the thought experiment and with respect to our actual social security system is to recognize that the healthy elderly can be a great resource, not just a burden to society.  Machines now do much of the physical labor that characterized jobs in 1935.  Today computers can also offset the impact of the declines in mental quickness and rapid recall that occur with age.  As such, they increase the value of wisdom that accumulates with maturity.  With the right incentives and proper policies, taking advantage of all the human capital possessed by the elderly population could produce an economic boom.  But it will take time for people to adjust, so we need to start reforming the system now.

Thursday, December 27, 2012

An Analogy for Thinking about Economic Policy

              In an earlier post, I wrote about how, despite the fascination with short-term economic stabilization policy, we actually know little about how such policy works (or fails to work) and that getting incentives right in the long run is more important in any event.  Here is an analogy that I find insightful in that regard.  It guides my thinking about economic policy.

              Imagine throwing a tennis ball into turbulent river rapids in which the water is tumbling and boiling.  My colleagues at Caltech would be the first to admit that predicting the path of the ball over the short-term is nearly impossible.  The churning of the water is just too chaotic on a second to second basis.  Over the course of a week, however, the path of the ball is highly predictable – it moves downstream at the average rate of the current.  The short-term fluctuations largely cancel out.

              Economies can be thought of in a similar fashion.  The short-run fluctuations are still far from understood, but their effect on a country’s standard of living pales in comparison to the impact of the “current” which is the long-run growth rate.  Getting the incentives right is so important because it plays a critical role in determining that growth rate.  An example illustrates this point.

              In 1960, Kenya and Taiwan were both largely underdeveloped agricultural societies with similar GDP per capita.  Over the next 50 years, the growth rate in Taiwan was one of the highest in the world.  As a result, by 2010 the standard of living in Taiwan was approaching that of the United States.  In Kenya, on the other hand, the growth rate averaged approximately zero over the same 50-year span, so that the standard of living barely budged from 1960.  

              The example is a vivid illustration of the importance of an economy’s growth rate in the long run, but it begs the question: what does it mean to promote growth by “getting the incentives right?”  As I discussed in a previous post, one instance of getting the incentives wrong is governments around the world making promises regarding retirement and health benefits that cannot reasonably be fulfilled.  I’ll talk much more about proper incentives in later posts.  But here is a nice current example from Edward Glaeser that is referenced Greg Mankiw's blog today.