Tuesday, December 12, 2006

Overestimating the Angry Bears

We wouldn't have thought it possible, but after re-reading the latest nonsense from them regarding Social Security privatization about 'free lunches' it appears that the claimants to Phd's in economics don't understand time horizons and their effect on risk/return ratios:

Simply put – the privatization crowd loves to lecture us that stocks pay a higher expected return than bonds, but then the same households they would transfer the Social Security Trust Fund bonds too likely know this as they also recognize the risks from holding bonds. Now perhaps M. Jed thinks these households are irrationally risk averse, while Barro and Becker would view their risk aversion as rational. But it makes no difference as to who is correct as these households would take these bonds and invest them in guess what – government bonds. Which means there would be no change in either risk taking or expected returns.

That bit of confusion being compounded in the comments section:

PRS tells us rational folks can make big returns by doing international diversification. Bruno Solnik vintage 1974! Now since rational person knows this - one would assume that private agents who don't do so are either irrational or more risk averse than PRS recognizes (oh wait, PRS doesn't get the risk point, but never mind). Either one - giving these risk averse or irrational folks (your choice Patrick) their government bonds is going to mean they'll continue to hold government bonds. And the return differential is zero.

And we say compounded advisedly, as that appears to be completely over the head of the author of both the above quoted bits.

Yes, in the short run, the greater risk of stocks (even negative returns are possible) may lead risk averse people to avoid investing in them. However, with retirement assets we are dealing with the long run, and in the long run risk is dominated by the greater returns due to the effects of compounding in the out years. As a simple (and outlandish) example will demonstrate. Suppose a twenty-five year old worker wanting to retire at age 65 ponders two choices of investment:

Each $1 invested at 3% (compounded annually) in a government bond for 40 years would be worth $ 3.26 at the end of the period. Meaning that a $10,000 bond would be worth $32,600.

Each dollar invested in a poorly performing equity mutual fund--averaging 7% compounded annually--would be worth $ 15. Thus a $ 10,000 investment would be worth $150,000.

But, suppose disaster strikes: An even greater market plunge than the Great Depression hits on the day our worker wishes to retire (and purchase an annuity with his retirement monies) and half the value of the mutual fund is wiped out, and our retiree is left with only $75,000.

However he's still better off by a factor of more than 2 than he would be had he taken the less risky route.

And there are three ridiculous assumptions in the above scenario. A riskless rate of 3%, a 4% risk premium over that, and a stock market drop greater than that in October 1929 (33%).

All because after about 15-20 years the greater return on stocks outweighs the greater volatility.

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