Wednesday, June 19, 2013

Finance and Personal Finance

I just presented a working paper at the Academic Forum in Quebec City.  I presented a standard empirical finance paper about whether a certain type of risk (crash risk) is priced across stocks.  Since the conference is quite general, many in the audience were not finance types.  I did my best to try to make it as intuitive, but in the end many were left thinking, "Whaaa?"

I got one comment afterwards from a professor in Hospitality Management that I wish had been given during my session, "I think the finance presentations need to do a better job of explaining why their paper is important to me."  In context, she was really talking about her own personal finance.

I think there is a really important and robust finding in Finance that addresses her question.  Personal Finance is really, really simple, and it doesn't require understanding or reading any current finance research.  Buy a diversified portfolio of stocks and bonds with as low management fees as possible.  For a 40 year old, buying 60% stocks and 40% bonds in low cost index funds gets you almost all the way there.  If you don't like risk, but less stock.  If you are younger buy more stock.  There are lots of more technical questions you could ask, like how much in corporate bonds vs. treasuries or should I buy international index or REITs or commodities.  But getting the general advice, diversify in low cost funds, gets you almost all the way there.  The more technical the question beyond that the less it matters and the less I am in the answer.  Asking, "how much of my portfolios should I put in REITs?" depends much more on information about you personally than research on the characteristics of REITs from the market perspective.

I presented some anomalies about how tail risk is priced across stocks.  I'm not confident I have addressed exactly right (there's some important things I'd still like to do), but if you believe my results, then there is a money making opportunity that's profitable compared to standard models of risk.  But even if you think, it is a profitable opportunity.  It's still not one YOU should invest in.  It would require lots of work to manage the portfolio and it would incur high transaction costs for an individual investor.  Quite possibly an investment manager or hedge fund would find the information useful and possibly profitable.  Certainly, a finance researcher is extremely interested in how risk and return are related, but its really of little use to retail investors.

One of the driving questions of Behavioral Finance is that personal finance is so simple and easy, why do so many investors ignore or fail at following the advice?  Most of finance research is geared to the (possibly too large) sector trying to discover prices, invest capital, and interpret financials.  Unless that is your full time job, just focus on getting the easy stuff right and spend the rest of your time and money on more enjoyable things.

1 comment:

  1. Whenever people ask me for stock advice, I always give them some variation of "While it may be possible to beat the market, the chances that you, some guy doing this in his spare time, will beat it are slim You should just try to buy the market by purchasing broad funds."

    Then they look at me like I just advised them to rape more dogs.