Bryan Caplan  

Four Bad Role Models

PRINT
More on Activist Medicine... From Religion to Real Estate...

Some Nobel prize-winning economists keep investing foolishly even though they know better, according to a recent L.A. Times article. Here are their statements, ordered from bad to worse:

  • Harry Markowitz, father of modern portfolio theory, put half of his assets in stocks and half in low-risk assets. Now he says "In retrospect, it would have been better to have been more in stocks when I was younger." OK, maybe the equity premium puzzle had yet to be discovered.

  • Clive Granger: "I would rather spend my time enjoying my income than bothering about investments." Isn't there some connection between the two?

  • Daniel Kahneman is more culpable: "I think very little about my retirement savings, because I know that thinking could make me poorer or more miserable or both."

  • But George Akerlof aggressively seizes the booby prize. He apparently keeps his wealth in money market funds and the like. His justification? Less than zero: "I know it's utterly stupid."

    The whole article reminds me of a quote I wrongly attributed to Einstein instead of Thomas Szasz: "Clear thinking requires courage rather than intelligence." It's sad that such eminent economists know the smart thing to do but fail to follow through.

    The sub-text of the L.A. Times piece, naturally, is that if Nobel prize-winners can't be trusted to manage their own investments, neither can average Americans. Of course, this dodges the crucial "Compared to what?" question. Is the typical American brainy enough to buy a well-diversifed stock-heavy index fund when young, and gradually move to lower-risk investments as he nears retirement? Probably not, though the history of index funds shows that many are.

    But the important question is a different one: Is the typical American brainy enough to beat Social Security? The answer is clearly yes. Buy bonds, stocks, managed funds, index funds, dart-throwing funds - whatever. They all beat Social Security in the medium- and long-run. Don't listen to Paul Ehrlich, and you'll be fine.

    By the way, if the L.A. Times had called me instead of these Nobel laureates, they would have gotten a different story. I often change my behavior in response to compelling research. Karen Lewis' excellent article on home country bias in the Journal of Economic Literature convinced me that I should drastically increase my ratio of international assets to domestic assets. After a brief "cooling off" period imposed by my ever-prudent wife, we went forward and made the change.

    Frankly, I would have been ashamed not to.

    Thanks to my Aunt Arlene for the pointer.


  • Comments and Sharing





    TRACKBACKS (9 to date)
    TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/255
    The author at The Club for Growth Blog in a related article titled Friday's Daily News writes:
      450 Economists Back Personal Accounts - Cato Institute The CAFTA Challenge - Financial Times Editorial Recommendations for Reducing Transportation Pork - NTU Defending Free Trade - Helle Dale, Heritage Foundation Congress’s Latest Christmas Tree ... [Tracked on May 13, 2005 9:36 AM]
    The author at Of Economies and Policies in a related article titled Great quote from Caplan writes:
      From a recent post on Social Security: Is the typical American brainy enough to buy a well-diversifed stock-heavy index fund when young, and gradually move to lower-risk... [Tracked on May 13, 2005 7:28 PM]
    The author at Half Sigma in a related article titled Why do people think stocks will beat Social Security? writes:
      Bryan Caplan writes: Is the typical American brainy enough to beat Social Security? The answer is clearly yes. Buy bonds, stocks, managed funds, index funds, dart-throwing funds - whatever. They all beat Social Security in the medium- and long-run. [Tracked on May 13, 2005 9:20 PM]
    COMMENTS (25 to date)
    El Presidente writes:

    Good to know.

    If we apply this awareness to the current debate on Social Security wouldn't we support privatization or discontinuation of the program? Wouldn't that allow industrious folks to earn a greater return on their savings? How many of these folks exist if even the brightest disobey their better angels?

    Or, would all of those taxes staying in people's pockets trigger a wealth effect and leave them just as bad off , if not worse, when it comes to their retirement? Is Social Security our last refuge from over-consumption?

    Maybe on average we just aren't "courageous" enough to save with consistency and discipline (then again, maybe it has something to do with wages). If only we could observe those admirable qualities of fiscal responsibility in federal budgets and tax policy. Maybe we would learn by example.

    John Ford writes:

    Excellent post Bryan! To put things into perspective though, I think it's important that EVERY investor has regrets, even the great Warren Buffett.

    He had a disastrous experience when he put Berkshire-Hathaway into US Air. When a Columbia Univ. student asked him why he did it, Buffett replied "My psychologist asked me that too. Actually I have an 800 number now which I call if I ever get an urge to buy an airline stock. I say, 'My name is Warren, I'm an air-aholic' and they talk me down."

    (from The Warren Buffett Way)

    Deb McAdams writes:

    Again and again.

    To beat the Social Security in a private account is not the point.

    You are not taking into account payments for the contemporary generation. Once those payments are taken into account, few investment schemes consistently beat Social Security, nor has anyone presented a reason, even in theory, why a given investment scheme should beat Social Security.

    Please be a little more honest in the future.

    There's a couple lessons in here.

    First, it is harder than it looks to translate theory into pratice for most people.

    Second, there's good reason to be suspicious of investment theory. This isn't physics or chemistry, after all, where you can perform rigorously controlled experiments to prove the theory right.

    Randy writes:

    Bryan,

    Re; Clive Granger: "I would rather spend my time enjoying my income than bothering about investments."

    I agree with Mr. Granger. In my opinion, the basic problem with Social Security is that it removes this choice. When did society start thinking it is necessary to protect people from freedom? Yes, I may end up poor and/or unable to retire. So what? Its my choice. You're afraid of free-riders? Only because you seem to think society has a duty to support people who prefer a life of freedom to a life of security. It doesn't. Ask them. They'll tell you.

    Robin Hanson writes:

    It is clear doing that most requires courage. Apparently many of these guys can think and speak clearly. But when it comes to doing ...

    Will Wilkinson writes:

    Hey Bryan, Here's a research idea. Find out whether the investment behavior of economists with more pro-market ideology is more consistent with economic theory than economists with less pro-market ideology. That would be interesting. You can call it "Putting Money Where Your Mouth Is."

    Bob Dobalina writes:

    Is the typical American brainy enough to buy a well-diversifed stock-heavy index fund when young, and gradually move to lower-risk investments as he nears retirement?

    Didn't Ibbotson, Sinquefeld, and others show, for withdrawal rates greater than 4%, that staying in equities until death was a better strategy than shifting into bonds?

    You are not taking into account payments for the contemporary generation. Once those payments are taken into account, few investment schemes consistently beat Social Security

    That would be the 'sunk cost' fallacy.

    Btw, this news article isn't the worst thing that's been said about Akerloff. I've been told (privately) something about: '...sense...come in out of the rain."

    Bruce Cleaver writes:

    Randy wrote:

    "In my opinion, the basic problem with Social Security is that it removes this choice."

    That is also an enviable feature. Not everyone is cut out for doing the hard work of investing and risk-taking - Daniel Kahneman for example.

    Don't misunderstand me; I want the choice as much as any of you. Not everyone does, though, and I bet that sliver of citizenry is larger than most of us think.

    Bruce Cleaver writes:

    The supreme irony is that Daniel Kahneman is a celebrated researcher in Prospect Theory, risk, and decisions under uncertainty.

    Randy writes:

    Bruce,

    If you are correct, that there is a large group of people who favor security over freedom, then let's have a voluntary program. Certainly this large group can come up with sufficient funds collectively to take care of their security needs.

    Bernard Yomtov writes:

    Why the superior tone and accusations of foolishness?

    The first three quotes are clearly defensible, especially Markowitz. Isn't one of the insights of portfolio theory that the investor's principal decision is allocating investments between risky and risk-free assets, and that there really is no optimum allocation, but that it simply depends on the investor's risk preferences? So Markowitz made that decision in accordance with his risk preferences.

    In hindsight he would have made a different allocation. Big deal. In hindsight we all would have invested differently. Why does that make Markowitz' decisions "stupid?" That's like saying that not going to Las Vegas and betting on red is stupid, because after all red came up twice in a row.

    As for Granger and Kahnemann, isn't there a case to be made, to put it mildly, that the best thing for an individual to do is just invest in a broad market portfolio? Isn't that what you more or less advocate in this post? So if Kahneman and Granger do that, and don't spend a lot of time fretting over which biotech startup is going to be the big winner, their behavior and statements make perfect sense.

    mark writes:

    I'd like to know in what context these statements were made. I suspect the writer intended to show them in a poor light.

    Lancelot Finn writes:

    Deb McAdams writes:

    You are not taking into account payments for the contemporary generation. Once those payments are taken into account, few investment schemes consistently beat Social Security, nor has anyone presented a reason, even in theory, why a given investment scheme should beat Social Security.

    The notion of "beating Social Security" implies that Social Security is analogous to an investment scheme or a private insurance contract. It's not. Up till now, recipients of Social Security have done well by the program, but that has nothing to do with Social Security having been a good "investment," or an investment at all; it's simply that they've have the political clout to rip off younger generations.

    Social Security is a negative-sum game. On the one hand, it's a tug-of-war for social resources: you win if you get benefit hikes after you retire, you lose if the retirement age rises just before you would have retired, you win if your the first generation and pay nothing in, you lose if you're further down the line, etc. This tug-of-war is costly, in terms of uncertainty about the future (more young people believe in UFOs etc.), and in terms of the costs of lobbying and the corrupting effect of large-scale rent-seeking on the practice of democratic politics. But what really makes the game negative-sum is that by reducing young workers' incomes, and raising retirees' incomes, you reduce the incentive to save. Thus, ever since the reforms that shored up Social Security in the 1980s, savings rates have trended relentlessly downwards.

    Investing privately is a positive-sum game. Entrepreneurs take risks for high return, we pool our risks in the market, we all get low higher returns and lower risk.

    Social Security reform is about switching from a negative-sum to a positive-sum game. To say that there is no reason "why a given investment scheme should beat Social Security" at the individual level is meaningless, comparing apples and oranges. But if we compare them on the societal level, there are plenty of overwhelming reasons why other systems of saving-and-investing for retirement would beat Social Security.

    spencer writes:

    Throughout history every generation has supported its old folks, no large population cohert has ever lived off of investment income.


    In in modern societies we have done it through public sector programs like SS rather then informal programs of kids taking care of their parents and private charity.

    But projecting that a large share of the population is going to be able to live off of investment income is projecting something that has never happened historically.

    Just goes to show you that the Republican party is no longer a conservative, they want to bet everyone's retirement on a completely novel approach.

    Do not ignore the advice of Samuleson that the history of the US stock market since 1926 is a sample of one.

    Geoffrey Brand writes:

    Bryan..

    Your comments in Micro 2 a couple of years ago convinced me to put half of my 401K contributions into a well diversified International fund.. Thanx..It has balanced out downturns in the U.S. market (in the future it might go the other way)

    Ashish writes:

    -----
    The sub-text of the L.A. Times piece, naturally, is that if Nobel prize-winners can't be trusted to manage their own investments, neither can average Americans.
    ----

    If nobody can be trusted to manage their own investments how can "we" trust "them" to manage "our" investments?

    jaimito writes:

    The premise that to become an Economics Nobel Prize winner and to be an index-beating money-manager requires the same kind of capabilities or inclinations, is wrong. Successful investors I know are not particularly clever nor understand economic theories. Some are stupid and their reasons for doing what they do - demonstrably wrong. The four bad role models are bad because they are not supposed to be role models for investors.

    Bernard Yomtov writes:

    There is some very strange thinking going on here.

    On the one hand, Bryan criticizes Kahneman and Granger, at least, as unwise for not working hard at their investments. This gets a chorus of amens from many commenters, who sneer at the economists for lack of courage, lack of faith in markets, inability to act, etc., etc.

    But then what do we find? Bryan describes an investment strategy of

    "buy a well-diversifed stock-heavy index fund when young, and gradually move to lower-risk investments as he nears retirement"

    which he clearly thinks is sensible, as do I.

    But how much work does it take it to implement this strategy? Reviewing your allocation maybe once a year? So why the criticism? How do we know that's not exactly what these people are doing? Is anyone here really suggesting that trading in and out of stocks, looking for the hot mutual fund of the month, and so on are good strategies?

    For the vast majority putting a lot of effort into investing is exactly what Kahneman, who is indeed an expert on decision-making, says - a way to get poorer.

    So stop the sneering.

    Tom writes:

    Bryan, I think you've fallen for what I call the "rationality fallacy." There's more to happiness than wealth-maximization, and the self-described behavior of Granger, Kahneman, and Akerlof simply illustrates that point. Many people prefer less wealth to more wealth if the price of more wealth is a lot of fuss, bother, and stress. Investing safely is one example of the preference. Another example is early retirement.

    Deb McAdams writes:

    Lancelot:

    If the argument is that on a societal scale, Social Security has a negative impact on investment or something, you do not bolster that case by saying "this investment will give better individual returns than Social Security" - which according to the original post was the "point".

    There can be an argument about the societal effects of Social Security, but that argument was not made in the post I was responding to.

    The post I responded do just made the argument, which you concede is a meaningless apples to oranges comparison, that most investment strategies have higher returns than social security (implicitly as long as you do not take current and soon-to-be beneficiaries into account).

    To the guy who thinks taking the current generation into account is the sunk costs fallacy:

    You do not know what you're talking about. Read again more slowly and try again.

    Tom West writes:

    Given the quotes, it seems pretty obvious to me that once again economists miss the point, even if they personally understand it, that many people put a very high value on security.

    The whole attractiveness of SS as it now stands over private accounts is the fact that bad luck can't condemn you to a poverty sticken old age. It's why old fashioned defined-benefit plans are the holy grail of retirement packages for so many people.

    Sometimes I wonder if economists could tell a group of 100 people "I'm going to double your income, but I will also shoot one of you in the head sometime in the next 20 years." and then not understand why the group doesn't sleep well for the next 20 years.

    Randy writes:

    Tom,

    Re; Sometimes I wonder if economists could tell a group of 100 people "I'm going to double your income, but I will also shoot one of you in the head sometime in the next 20 years." and then not understand why the group doesn't sleep well for the next 20 years.

    Interesting. Try it this way. The government says to 100 people, "I'm going to provide each of you a guaranteed income when you reach 65, but I'm going to shoot all but five of you in the foot once every year until then." Certainly there are some who would volunteer for such a plan - but not many, I think.

    Lex Spoon writes:

    Deb writes:

    "The notion of 'beating Social Security' implies that Social Security is analogous to an investment scheme or a private insurance contract. It's not. Up till now, recipients of Social Security have done well by the program, but that has nothing to do with Social Security having been a good 'investment,' or an investment at all; it's simply that they've have the political clout to rip off younger generations."

    I wholeheartedly wish more people thought like this. This is a statement of purpose, however, and to date, social security does not act like this. I wish it did, and I see private accounts as a way to transition back from SS-as-retirement to SS-as-safety-net.

    You are saying that SS is not a retirement program, and (by implication) that it is a safety-net program. A safty-net program protects people that screw up or have bad luck--a valuable service for a government to provide. The program we have now is very different, though. It pays out less to precisely those people it is supposed to be giving a safety net to. It pays more if you put more into the system. In short, it is currently set up exactly like a retirement system.

    IMHO, it would be great to transition to a safety net program. In such a beast, the payouts would *never* be on par with the retirement program of an average person. The maximum payout would be to someone who made 0 dollars in their lifetime, and it would be just enough to provide some minimum standard of living. That's a safety net.

    Such a program would be much cheaper, and tax payers would have more money left over to invest. Personal retirement accounts are a way to move from "investing" in SS to (a) using SS as a safety net and (b) truly investing the money that the much cheaper program does not need.

    It is a values question that should be at the center of the debate, but no one wants to talk about it. That's a pity, because I expect most of the country would agree on this principle of "safety net" versus "retirement account". SS-as-investment is indeed a wonky idea, but I don't know of any politician that will touch the question.

    Comments for this entry have been closed
    Return to top