Hints about the stochastic discount factor

Its a great mystery (if you assume asset return volatility is all that matters) why investors don’t hold more stocks. Sharar Pitaru at the neat new investment tool Plantly, says:

Yes, in general our rationale might lead to a greater investment in bonds then the ‘80/20 rule’ calls for.

I’d suggest that the 80/20 rule (and other ‘rules of thumb’ like it) carry hidden dangers to investors, despite how neatly they may organize things in our minds. The danger stems from the inability of such over-simplified rules to account for the human factor:

The rational for an 80/20 portfolio is that it is destined to fluctuate widely with the market, yet it is also predicted to provide good returns in the long run. Therefore it suggests that investing in 80% stocks makes sense for the long term. Notice that this rational works only if we really keep our money intact for the duration of the investment. But how many of us really do?

Unfortunately, in reality, investors have many external and internal reasons to break an investment when the market goes sour. For example, many investors ‘broke’ their 80% stock investment earlier then planned for because they were scared of losing it all. Other investors just had an emergency (like losing their job) and needed the money sooner then expected – smack in the middle of the crisis. In both cases, these investors missed the general tendency of the markets to bounce back and provide positive returns for the long run. If either of these investors understood the risks involved in breaking the investment sooner, they might have not chosen the 80/20 portfolio to begin with.

My second gripe with the 80/20 rule is that it reflects the tendency to consider all bonds as safe and all stocks as having the same level of risk. In reality this is not the case. I’d suggest that other types of mixes are also viable – even for long term investments – depending on the specific bonds and stocks that are being used.

Back to Plantly – our diversification rational is to create an investment plan that aims towards your chosen target return while reducing its risk as much as possible. And yes, sometimes this calls for a greater investment in bonds as you’ve noticed – but this only works with the right kind of bonds, when mixed with the right kinds of stocks.

(emphasis added)

Investors want to have investments that pay off when their marginal utility is low high. This is a bitch to model and measure (poor, poor economists that *have* to spend their careers obsessing about this problem), but its a pretty easy thing to believe.

1 thought on “Hints about the stochastic discount factor”

  1. I guess there are two puzzles: (1) why some people don’t hold stocks at all, and (2) why do the ones that do hold the quantities they do.

    Marginal utility? In general we would expect MUs to be more-or-less equalized across people (up to some multiplicative constant) due to either diversification or, more realistically, self-insurance. So this means that you actually want assets that do badly when the rest of aggregate income does poorly (?!).

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