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Dan,

1. For investors, two competing goals are preservation of capital and desire for growth. To oversimplify, a real-return bond likely has little risk of loss of capital (at least for government bonds) but substantial risk of lost opportunity cost due to real economic growth. A diversified stock portfolio, on the other hand, has substantial risk of loss of capital but smaller risk of lost opportunity cost due to real economic growth.

A person's tolerance to these two risks differs according to individual circumstance. For example, my mother, age 69, has little tolerance for lost capital risk, but a high tolerance for lost growth opportunity cost risk. On the other hand, my nephew, age 4, has plenty of tolerance for lost capital risk, but needs not to expose himself to the risk of lost opportunity cost due to real growth.


I realize that this is the standard spiel underlying asset allocation theory, but I don't buy it. As a value investor, I see greater safety of principal and better opportunity for real growth right now in bonds than in stocks. It's only an either/or proposition if you follow convention wisdom and make a lifetime asset allocation decision. If you believe in tactical asset allocation, as I do, then all you're arguing is that bonds make more sense right now than stocks, given current prices and conditions. Those conditions will change over time, and as my perception changes, so will my asset allocation. But I am nearly 100% confident that stocks (in aggregate) are substantially overvalued right now, and that investing in fixed income makes sense from both a capital preservation perspective and from a maximal gain perspective.

I do recognize, of course, that price imbalances can remain in place for many years-more than a decade. So your point about time horizons is certainly valid for a retiree who may not live to see valuation return to the marketplace.

Similarly, a person's tolerance to these risks changes as circumstances change. Assume that there is a specific amount of money that one needs to live for the rest of their expected lifespan. Once a person's wealth (which for these purposes should include expected income from one's labor) rises above that amount, he should see no risk from giving up real growth, but significant risk of any loss of capital. If a person's wealth is significantly below that level, however, capital preservation must take a backseat to the possibility for real economic growth.

Oddly enough, in the market of the past several years, many investors seem not to have behaved in this manner...


This paradox was discussed in "Against the Gods". I didn't make marginal notes when I read it, so I can't remember who described the behavior. What you describe as the way people ought to act is Bernoulli's Theory of Utility. Alas, humans aren't cold Vulcan calculators. They let silly little emotions influence what they do.

Your point is that in the view of experts, the risk of loss of capital by investing in stocks is above average at this time, while the risk of lost opportunity cost from real growth is below average. Given that, one's natural predilections toward avoiding one risk or the other should be skewed to some extent toward capital preservation. But as jrr7 points out, this does not necessarily mean that a given person should completely eschew stocks as an asset class. For my nephew, even a small risk premium is enough to justify choosing stocks over a real-return bond.

I believe that the equity risk premium is currently negative, even for your nephew. That doesn't mean he should never invest in stocks, just that he shouldn't do so right now (again, let me emphasize, I mean a broadly diversified basket of U.S. stocks).

2. If you define the "US Stock Market" as the S&P 500 or the Wilshire 5000, then US GDP is not necessarily the correct measure of economic growth. If companies can direct investment toward countries with higher GDP growth rates, then their stock values should be more closely correlated with the GDP of those countries. Obviously, US GDP is a substantial fraction of world GDP, and many other countries' GDP figures are strongly positively correlated to the US. But this is still a factor to remember.

I'm a strong skeptic of the "world market syndrome", which has been used to justify lofty valuations in Gillette and Coke, among others. Can the third world really afford to shave with disposable Mach III Razors, or to replace 80% of their daily fluid consumption with fizzy flavored sugar water? I routinely jump into foreign markets when they seem underpriced or undervalued (I'll confess that I have a hard time assigning value). But I think this is a better argument for investing in foreign markets (e.g. India, China) than for investing in U.S. multinationals.

3. Because of tax preferences for stocks over bonds, investing in stocks as an inflation hedge may have smaller frictional costs than investing in real-return bonds. If the difference between ordinary income and capital gain rates is 15% (e.g., 35% v. 20% in US), then using real-return bonds to hedge against an eventual 10% inflation rate will cost you 1.5% more annually than using stocks. Of course, if tax-advantaged accounts are available, the problem goes away.

Tax and friction issues can sure shoot the hell out of EMT, can't they? Does anybody who doesn't have the state tax-payers contributing a 4:1 match to their defined-benefits pension plan even believe in EMT anymore? Sadly, I know they do. Obviously, I do not.

4. I suspect the frictional costs of short-selling are far higher than those available for long stock investors. I may be mistaken, as I have little experience with short-selling.

You're right about that. I can only speak for how it works in Canada, with my brokerage. Short sales are taxed on the income account (ca. 45% marginal tax rate), rather than on capital account (ca. 22% tax rate). I also have to pay a full-service commission on the front side (twice the discount rate), but I can close the position with a discount trade. I need sufficient margin to carry the position (usually at 30% of the cash value of the short sale), and I pay prime rate interest on the net-change in value if the position moves against me, whereas I earn cash interest on the net-change if it moves in my favor.

Bonds provide nearly as much ballast (margin room) as cash does (90% vs. 100%), so I feel pretty comfortable carrying long-term short positions backed by cash or bonds. I feel less comfortable when all my account equity is in stocks and I use that equity for margin to sell other stocks short.

5. Your model assumes a cyclical reversion to "underlying value". While I happen to believe that such cycles exist, I also admit that premiums to underlying value can persist for relatively long periods of time. To the extent that I value being able to make use of my investments during my lifetime, it does me no good if I correctly identify such a premium but it fails to revert in time.

Absolutely, but if I'm going to wait out a long-term position in equities (be it short or long), then I want to have valuation behind me. I've got tremendous tolerance for riding out a deficit if I'm confident I've got value on my side, but next to none if I'm just speculating on a market trend.

Todd
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