An Economist Gives Investing Advice

Harvard professor Greg Mankiw writes in the New York Times on how economists look at the stock market. He makes several good points except I’m afraid he includes the Efficient Market Hypothesis which only seems to be believed in academia.

The other points Mankiw makes are that the stock market’s moves are often inexplicable. This is absolute true. I recently pointed out that the standard deviation of the Dow’s daily change is more than 40 times its average change. That means there’s a lot of noise in there. Mankiw writes that holding stocks is a good bet. I’d add that it depends on which stocks you hold.

In 1985, Rajnish Mehra and Edward C. Prescott, both now at Arizona State University, published a paper in the Journal of Monetary Economics called “The Equity Premium: A Puzzle.” They pointed out that over a long time span, stocks have earned, on average, about 6 percent more per year than safe assets like Treasury bills. This large premium, they said, is hard to explain with standard economic models. Sure, stocks are risky, so you can never be certain you’ll earn the premium, but they are not risky enough to justify such a large expected return.

Since the paper was published, economists have made some limited progress in explaining the equity premium. In any event, the large premium has convinced most of us that stocks should be part of everyone’s financial plan. I allocate 60 percent of my financial assets to equities.

The buy-and-hold philosophy is widely mocked nowadays even though it’s been a huge winner for the last three years. Mankiw also stresses the importance of diversity and investing outside the United States.

Posted by on May 20th, 2013 at 10:19 am


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