Why people invest in stocks

By Felix Salmon
May 18, 2010
Eric Falkenstein has a great blog entry on the relationship between risk and return, riffing off my post on what stock-market volatility should do to investors' asset allocation. Essentially, he says, the idea that returns increase with risk is simply wrong:

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Eric Falkenstein has a great blog entry on the relationship between risk and return, riffing off my post on what stock-market volatility should do to investors’ asset allocation. Essentially, he says, the idea that returns increase with risk is simply wrong:

Steve Sharpe and Gene Amromin found that in questionnaires investors tended to have higher return expectations when they forecast volatility as being relatively low, and lower return expectations when they forecast lower volatility. Exactly the opposite of what they should be thinking. This isn’t a missing a constant in the second decimal, rather, screwing up the sign.

As this is consistent with the theme of my book Finding Alpha, I thought this paper was awesome, and asked Steve Sharpe why it wasn’t in a journal. He noted that referees just kept sending it back for various reasons. This is unsurprising, because all the referees presume there must be some sort of mistake, that this can’t be true; it’s counter to all their theoretical training. …

Sharpe’s result really puts the standard model in a box. Unlike the CAPM betas, for which we can say we ‘just don’t know the true market portfolio’, this result takes fewer assumptions, so its empirical failure is all the more fatal to the core financial theory. People should be increasing their expected returns in volatile markets, and on average that should manifest itself in actual returns. We don’t see that in actual returns, or in surveys of expected returns.

A powerfully bad theory is like a lie–it has many inconsistencies because it isn’t true (a worse bad theory is wrong and consistent with the data, but merely because it doesn’t predict anything). One of the many bad implications of having the delusion that risk begets a higher expected return is that people invest in the stock market thinking they then deserve a higher return, a strategy that worked pretty well in the U.S. in the 20th century.

This is the heart of my case against investing in stocks. For one thing, you have no good reason to expect an equity premium going forwards, and if there isn’t an equity premium, then your allocation to stocks should be tiny: you’re not being compensated for the extra risk you’re taking. On top of that is the question of volatility, which is not exactly the same as risk, but which again should be compensated for with higher returns, and isn’t.

My feeling is that people like to invest in stocks because they like knowing that there’s a chance that the stock market will solve all their financial problems when it rises. Think of it as a three-pronged strategy: buy a house, invest in stocks, and work hard. Any one of these three things can pay off with lots of money at retirement, in the way that investing in TIPS won’t.

What’s more, an entire generation of Americans started working and saving and buying a house in the early 1970s — and millions of them hit the trifecta, becoming successful in their careers even as their stocks rose and the value of their real-estate soared. I doubt that particular combination is going to happen again in the U.S., but the experience of that generation is so powerful as to give a lot of people a lot of hope. Even if that hope isn’t particularly rational.

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