To think like an economist when investing, don’t listen to conventional wisdom

To think like an economist when investing, don’t listen to conventional wisdom by Allison Schrager When the markets tank and take a chunk of your wealth, all that gets you through the day is faith; faith your financial advisor knows what he's doing or, if you pick your own investments, that your strategy will hold up. The last week has been a big test in my faith not only as an investor, but as an economist. That's because while many of my peers don't apply economics to their investing, I actually do. Right down to my Fama-French tilts. My portfolio is a near perfect reflection of my macro training and half a dozen years mentored by Nobel Prize winners on how to adapt high finance to retail investing. But that approach sometimes puts me at odds with advice pushed by the personal-finance industry. My brokerage firm says my strategy is too aggressive and not well diversified, even though I consider myself risk averse. Where we diverge is how we define risk. Their strategy seems built to ensure I'll never lose or gain much more than most other people in any given day. But that strategy does not necessarily satisfy my personal investment goals. I don't care how I stack up against my friend's portfolio. I follow what economists call life-cycle investing—a combination of maximizing my wealth and never taking a big hit in terms of my lifestyle. Somedays I'll do much better, other days much worse than people I know. Indeed, my strategy put me in the worst performing stocks lately. And I was warned: The brokerage firm where I keep my money has an algorithm that regularly assesses my portfolio and it keeps telling me I am invested all wrong. But I am still not giving up (or looking at my account balance). Here's why I have faith in my choices, even if they look off target by certain standards: How I view my assets For obvious reasons the brokerage firm steers me into their high fee mutual funds. My finance training fights their recommendations and I go with cheap indexed funds. Index funds have become the go-to investment choice these days, but the ones I chose is where things get controversial. Bonds, for example, only make up 7% of my investment portfolio, which I'm told is not enough. The conventional wisdom is that younger people need fewer bonds, but how much exactly seems to vary with the current state of markets. Right now, bonds are up, stocks are down. The brokerage firm tells me my 7% should really be 25%. But since you can't time markets I'm sticking with my choice. Besides, I think I already have enough bonds. My largest asset isn't my stock portfolio, it's my future work income because I am still relatively young. Future income—essentially a stream of payments I expect—is similar to a bond. And by my calculation, my true bond exposure is more like 65%. So even if the stock market drops, my actual wealth has not changed that much.  As I get older my future earnings will be a smaller share of my portfolio and I plan to move into bonds. But my reallocation will be driven by the length of my remaining career and how risky my earnings are, not the current state of the market. How I see markets As bad as the US stock market is, other countries are in worse shape. I am regularly told my portfolio has too much foreign exposure. Across all my accounts I have about 35% of my portfolio in foreign stocks, and I'm told I should have just 21%. But, like all good economists, I eschew any home bias. My income is already tied to the US economy, so why put almost all my wealth there? The US economy may look better than the alternatives today, but that may not be the case in 30 years. Perhaps the US will prove more stable, but that may mean less growth over the long term. My macro training and belief in the power of markets lead me to believe—present turmoil aside—poorer countries will grow faster than rich ones. Their demographics are better and there is more upside potential. So not only am I heavy in foreign stocks, I own lots of stock in emerging markets, which are getting pummeled. But my finance training tells me there's no reward without risk. Emerging markets promise higher returns, but they come with weeks/months/years like this. How I determine my savings I'm also told I'm not saving enough for retirement—which is strange since I'm a pension economist. When I signed up for Quartz's parent company's 401(k) recently I got many stern warnings that I should save at least 10% of my income for retirement. Instead, I'm only saving up to the company match because anything less is leaving money on the table and anything more ties up my money when I need liquidity. I agree 10% is the right goal and I am actually saving that much—just not in my 401(k) or the stock market. My usual career choices expose me to variable income, but I like to maintain a stable lifestyle. That means I need to keep a large amount of liquid savings invested in cash or short-term securities. I'm prepared for days like this, and that peace of mind affords me the luxury of not looking at my brokerage account. Sometimes I think the brokerage firm is right. Not because a stock market plunge killed my portfolio but because I am poorly diversified in one sense. My professional reputation, and future earnings, depend on economic and finance theory being right. I am long economics in both my wealth and future income. In that sense, I am totally exposed. Allison Schrager | August 25, 2015 at 9:00 am | Tags: 401(k), banking, bonds, Economist,Emerging Markets, investing, Portfolio, retirement, stocks | Categories: Uncategorized | URL:http://wp.me/p2G6tR-22tZ