Financial Economics Corner: Investing and Economics Part 1

by robekulick

A couple of people have recently been asking me how I invest and what economics has to say about investing. So as a practical entry, I thought I might show a few sample portfolios and discuss the economic benefits. This post ended up being pretty long, so the discussion will have to be broken up into parts. I’m told by a few lawyers in my reading base that I could get in trouble if I am perceived as offering investment advice…in fairness, I guess economists have been criticizing the legal system for a long time, so it’s to be expected that they would want to be mean to us, but the inefficiency of that even being an issue is striking. But to be safe, THIS IS NOT INVESTMENT ADVICE…it’s just economic wisdom. However, if your broker or financial advisor disagrees with any of this, perhaps you should…well, take him out to a very nice dinner and explain to him carefully why he’s been wrong for the last 30 years or so and tell him that some 27 year old PhD student told you so…at that point he’ll be so mad he’ll quit, you’ll be free, and it’s not my fault because all you did was have an honest sharing of ideas and ideas are protected by that Constitution-thing I think.

Now some people are aware that in economics there is currently a huge debate between people of the efficient markets school of thought and people who believe that financial markets have significant inefficiencies that people can exploit for personal gain. But, in a rare example of agreement, almost all economists believe that the average investor should invest in passively managed, low-cost funds – either index funds or equity ETFs. Behavioral economics has also shown us that the more complicated investing becomes, the more people just don’t do it or go back to their old, costly ways. So here is an example of a portfolio containing only 4 funds that can be your entire portfolio, give you total worldwide diversification, keep your investment costs very, very low, and I would GUESS is about 90% optimal (by that I mean if you do only this you’d still be in good shape).

Portfolio (1):

iShares Barclays TIPS Bond Fund (Symbol: TIP)

Expense Ratio: 0.20%

Vanguard Total Stock Market ETF(Symbol: VTI)

Expense Ratio: 0.07%

Vanguard Emerging Markets ETF (VWO)

Expense Ratio: 0.22%

Vanguard MSCI EAFE ETF (VEA)

Expense Ratio (0.12%)

The average actively managed mutual fund has expenses on the order of 1.5% to 2.0% and recent research suggests that when hidden expenses are accounted for (not to mention loads) it is 3.0% or higher. Obviously those expense ratios in my sample portfolio are far below what you would otherwise be charged and that’s good because you get to keep more of your money. Now you may ask at this point, why buy funds…can’t I just buy individual stocks? And the answer is you could, but by buying these 4 funds you’re getting thousands of securities with very few trades. Since trading costs money, buying thousands of securities on your own isn’t feasible…especially because to keep your portfolio constant you’d have to constantly be buying and selling small amounts of those securities.

So what exactly are these funds?

TIP is a fund that holds an assortment of  U.S. Treasury-Inflation Protected Securities which are literally the safest asset in the world because they’re indexed to inflation so the only way you lose your principal is if the U.S. defaults. Current hysteria aside, even under dire economic forecasts for the next 30 years, the U.S. is highly unlikely to simply default on its debt. If  we do not fix our spending problem and there is a crisis, the U.S. government will end up doing what countries have done since money was first invented. It will print money in order to precipitate inflation. Luckily, by holding these bonds you’ll be protected from that! Pretty cool, huh?

VTI is the broadest index of U.S. stocks available from Vanguard and is as close as you can get to owning every stock in the stock market. For theoretical reasons, this is exactly how economics says you should invest. The theory can be discussed in another post, but the basic logic is diversification.

VWO is the Vanguard Emerging markets stock fund. This is a good time to share another economic lesson about investing: IT IS VERY IMPORTANT TO OWN STOCKS IN COUNTRIES THAT ARE NOT THE US! Again it’s about diversification. You should be fully aware that emerging markets can be extremely volatile, so if you don’t want to go this route, you can get foreign exposure from more established countries through the next fund I discuss. However, emerging markets are overall less correlated with the U.S. Stock Market than developed European markets so that is something to consider. Also, if you want higher returns, you’re going to have to bear more risk and so if you have a long-time horizon, this is a very good thing to have.

Finally VEA is an index of developed foreign countries. Sort of like VTI but for Europe and Japan and such.

The final question is how to decide what percentage of your portfolio to put in each of these investments. For 99% of the population, the book A Random Walk Down Wall Street by Burton Malkiel is the best book on investing our there. Yes, yes, I’m very familiar with the work on inefficient markets, and I’ll talk more about that later, but really even if you don’t fully agree with him, his allocation advice is great.

However, to summarize the issue, your allocation decision depends on how much risk you want to take and how long you’re investing for. Personally, I don’t think people in their 20s-30s should hold U.S. bonds. We have a long time horizon to recoup our investments and I personally like a nice risky portfolio. But for instance a 20-30 year old COULD, (this is not should-I’ll have to explain later what theory suggests you should do but it adds unnecessary complication) do something like options (1) or (2):

Fund Option 1 Option 2
TIP 0% 10%
VTI 45% 45%
VWO 20% 15%
VEA 35% 30%

 

These percentages are pretty arbitrary, but my purpose in showing you this is just to show an example and to indicate that it’s more important just to pick some percentages based on the relative riskiness of the asset and go with it. You may ask, are these percentages how I personally invest and the answer is NO! I have a much riskier investment profile which will have to be discussed in a different post. But it still relies only on passively-managed index funds and ETFs!!!!! This is the key lesson no matter what you do.

If you’re nervous about this, you may want to talk to your financial advisor to establish the exact percentages…they should have software that will help. Also, if you’re a little off it doesn’t really matter. This part is something of an art and it’s more important that you invest this way than getting the percentage exactly right. If you aren’t currently investing in index funds or ETFs like the ones above, then I can almost assure you that you’re probably nowhere near the allocations you should have unless you’re very sophisticated and in that case you must be really bored by now. So don’t worry about screwing up the percentages!

Wow. So this post has already gotten very long, and I haven’t even gotten through half of what I’d hoped to, but I think this is enough for today. But just to explain a bit why there’s more, I described this as 90% optimal above. Financial economics is one of my passions so while the remaining half of what I have to say is far less important, it is more involved from an economics standpoint…though still quite simple in practice…it really just takes a bit more explaining.

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