Felix Salmon

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:

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.

17 comments so far | RSS Comments RSS

While the Sharpe and Amromin study shows that people haven’t internalized portfolio theory, it doesn’t necessarily disprove the practical implication that riskier assets have higher returns. In fact if most investors feel that high volatility equals low expected returns, the demand of assets will fall when they become more volatile, decreasing their price and increasing the true expected return.

Posted by Stevensaysyes | Report as abusive

“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 seems to say that they expect both high AND low returns with low volatility. I’m confused….

For your main point, why people “believe” in stocks, I agree with what you say as far it goes, but would also ask what makes them believe that. I’d point to an entire industry that makes it’s living by promoting “magical thinking” about stock investing. Think of the startlingly large font full page ads that Merrill and Fidelity, to name but two companies, put in the NY Times Business section almost every Sunday. It’s pretty obvious why they are doing this. Stock brokers work on commission, and mutual fund companies get fees based on funds under management. That’s the motive. And on the other hand, there’s not much money to be made by telling clients to put their nest eggs in TIPS, FDIC insured CDs, or other set and forget safe investments. And one reason for that is that no one wants to hear that, because it means that they will actually have to stop spending and borrowing so much and instead save a fairly high portion of their income if they want to have a comfortable retirement. How do you win an election with that message? It’s downright un-American.

Posted by maynardGkeynes | Report as abusive

The percentage of the population that invests in stocks has ebbed and flowed over time. Generally speaking equities were loved until 1929, unloved until WW2, loved until late 1960s, unloved until the early 1980s.

See the SCF chart book. This one tracks equity ownership from 1989-2007 (mostly an increase) but this data has been collected back to at least 1962.

http://www.federalreserve.gov/pubs/oss/o ss2/2007/2007%20SCF%20Chartbook.pdf

Stocks were unloved for the duration of the 1970s and early 1980s. Though high inflation contributes to the low P/Es by the early 1980s the 10 year trailing P/E was in the single digits.

http://www.econ.yale.edu/~shiller/data.h tm

The rise of mutual funds and defined conribution plans probably didn’t hurt the equity culture of the past 25 years either.

Valuation matters.

Posted by david3 | Report as abusive

If people subscribe to your theory and allocate away from equities because they’re too volitile, that will increase the expected return of equities. Thus, equities (at least the volitle ones) will have higher expected returns. Wouldn’t this, in the end, disprove your ultimate conclusion?

Posted by DaDaDan | Report as abusive

In theory the stock market should work with supply and demand dictating risk and returns. However, the market is manipulated to such an extent by Wall Street insiders, that it is no different than going to Vegas for a weekend.

Posted by TheMiddleWay | Report as abusive

People are investing in stocks these days because banks are paying 0.01% interest. Compound that over 30 or 40 years and you end up with less than what you start with, after accounting for inflation. With stocks, you might actually match inflation, and if you are better or luckier than average, you might even do a little better.

Posted by OnTheTimes | Report as abusive

To modify a famous quote: We cannot ensure success, but we can ensure failure. Here are some strategies that definitively will fail to earn the necessary rate of return for an average American wage-earner to afford a middle-class standard of life and retirement:

1. Allocating in and out of equities based on things you read on blogs – especially guesses by guys who have difficulty with elementary statistics about future equity return premiums.

2. Following one such clueless blogger and allocating 100% fixed income in a time of low interest rates and possibly high future inflation. What are TIPS paying, 1% real after-tax as long as you trust the U.S. government not to mess with inflation statistics or the tax code? Please. That’s not an investment.

Fixed income doesn’t get there return-wise. Additionally, much fixed income is significantly riskier than quality equities. Compare the leverage and inflation/devaluation risk of any government debt or any financial company to the leverage of any high-quality equity in an essential business with pricing power. But if the rest of you want to make negative real returns, go ahead – I don’t need you crowding the equity markets and pushing up prices in boom times to where I can’t put money to work effectively.

Posted by najdorf | Report as abusive

I invest in stocks precisely because of the volatility, and prefer small cap stocks because of their inherently higher volatility. A single stock 100X’ing in value – going from 1B mkt cap to 100B, or 100M to 10B – from a small company to a large one, makes up for a lot of losers – 100% go bankrupt losers. It’s also what investing is supposed to be about – giving people money to grow their business.

Where people go wrong is pulling out of stocks after a down stretch in a period of high volatility. They miss the upswing after eating the downswing.

Posted by winstongator | Report as abusive

A more interesting question would be: Why Do Good People Invest in Bad Stocks?

And then try to do something about it.

Posted by HBC | Report as abusive

“in questionnaires investors tended to have higher return expectations when they forecast volatility as being relatively low, and lower return expectations when they forecast higher volatility.”

In the short and medium term this makes perfect sense. If we expect volatility to go down then we can expect valuations to go up and so we can expect that returns on what equities we currently own will be high during the climb up. In the term of decades it’s a different story, share buybacks will be purchasing equities at too high prices for too long.

Felix, you recently cited and praised an article by Jeremy Siegel on P/E ratios, which described how earnings can be considered as the equivalent of dividends (currently at ~7%). Do you really understand the article and implications? Those earnings can be used for dividends, share buybacks, investments and paying down debt. In fact,theoretically, the options besides dividend payouts should increase shareholder value as much or more than dividends.

Posted by cjkubx | Report as abusive

Why don’t you believe there is an equity premium? Is that not evident on its face?

TIPS yield less than 2% right now. Top consumer companies with steady businesses and AAA credit ratings yield 3% or more right now. Both payouts (and values) are likely to rise with inflation, however the consumer products company is also likely to profit somewhat from investing its retained earnings on expansion into new markets.

Top quality stocks ought to beat inflation by 4% over the long run. Investment-grade bonds can likely beat inflation by about half of that. There is absolutely a premium for investing in stocks, nor is it clear to me that the investment is any riskier. (More volatile, for sure, but you admit that is distinct from long-term risk.)

We are at the END of a period in which bonds have performed almost as well (or better) than stocks — at least if you stayed away from arcane mortgage securities. However these things tend to be cyclic. Bond yields are ridiculously low right now, and any increase in yield will take its toll on the sale value. Stocks are also expensive, historically speaking, but less so than bonds.

I do agree that the siren song of massive wealth drives SOME segments of the stock market to irrational heights, however there are other segments that are predictable, relatively stable, and consistently profitable. You won’t get wealthy from such investments, but you absolutely will outperform bonds.

Posted by TFF | Report as abusive

Some of the points in the discussions of “equity premium” appear to be inconsistent, because return is treated as an abstract number. The problem is that there is no way that any price discount at a single point in time can relate to a perpetual difference in annual return. For example, if you thought that stocks ought to trade at a discount of 10%, say, because of the “equity premium”, then you should expect that discount not just today, but next year as well, so it should not affect your expectation of any capital component of total returns. The only component of stock returns which should be affected by a price discount is the dividend yield, and that by a small amount because a 10% discount makes a 10% change in the dividend yield, say from 2% to 2.2%.

The main permanent difference between stocks and bonds is that stocks represent ownership of a share of the economy and the average capital component of stock returns should, on the whole, follow the economy. If the size of the economy grows then the diversified stock owner goes along for the ride. Of course, he is also strapped into his seat on the downswing when the economy shrinks.

The growth in the size of the economy is not directly comparable with a fixed dollar return on a bond, which is why the classic advice to have some of each makes sense. But neither one should be expected to return more than a few percent per year.

Posted by BlackBox | Report as abusive

I did a quick and dirty calculation using the S&P500 and a a simple EMA trendline.

Daily Return Above Trendline
Min -6.87%
Max 5.12%
Avg 0.09%
Median 0.08%
Std Dev 0.78%

Once the trendline is broken to the downside the markets become much more volatile

Daily Return Below Trendline
Min -20.47%
Max 11.58%
Average -0.09%
Median -0.08%
Std Dev 1.38%

You can see the daily return standard deviation jumps by 60 bps.

Now this isn’t a total return calculation so there are no dividends incorporated here but just based on the the prices. However, investing below the EMA trendline turns $1 invested into $0.02, meanwhile investing only above the trendline turns the $1 into $663.93.

Tends to back up your asset allocation model you posted on the other day, where as the volatility increases it is time to wade out of the markets. Need some more time to play with it to decide if volatility is causing lower returns or as momentum fades it increases the volatility.

Posted by tcolemanuf | Report as abusive


There is a smarter portfolio approach that places heavy emphasis on safety of principal, liquidity and income, yet simultaneously provides investors with compelling potential for capital appreciation (that also embraces your preference for small caps)…

http://venturepopulist.com/2009/06/hybri d-portfolio-theory/

Posted by JoeyNatomas | Report as abusive

Most “investors” complicate the investment process, use poor judgment and succumb to emotions to distract themselves from achieving their long-term financial goals.

Most fail to realize that it is their behavior, rather than short-term market performance, that will have the most effect on their achieving their goals. Some fail to start early enough. Some fail to invest enough. Many sell out of fear in troubled times and buy back overconfidently after rebounds. Fads are chased and “expert advice” is taken from those who know nothing of the person’s situation, time horizon or investment goals.

These behavioral mistakes explain why most are not financially wealthy.

Posted by MGabel | Report as abusive

I’m not sure where Felix gets his “feeling” that people invest in stocks to have a chance to solve their financial problems, I personally invest in stocks because I see opportunity for better returns than cash or bonds. In my experience people who are not active investors/traders don’t have the knowledge or discipline to be effective investors. I find this particular blogger to be snobbish and cynical about markets and trading in general. It must be nice to be so “smart” to avoid such dangerous opportunities.

Posted by centralplains | Report as abusive

I understand that “gurus” (normally) associate higher returns with higher volatility — and would sigh (with some disgust) at the results of the questionnaire.

But what are the (historical) facts?

Investors are schmarter than you think :^)
http://ponzoblog.blogspot.com/search/lab el/Returns%20vs%20Volatility

Posted by gummy | Report as abusive

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