The Allure of Fool’s Arbitrage

BY Paul Solman  November 15, 2011 at 5:14 PM EST

Money or Mortgage

Paul Solman answers questions from NewsHour viewers and web users on business and economic news here on his Making Sen$e page. Here’s Tuesday’s query:

Name: Eriks Blaschka

Question: My smart colleague told me that he would be happy to “never” pay his house off, but rather pay until he is 90.

His reasoning: While his payments stay at a given level, around $1000 a month, in 20 years this amount will be peanuts due to inflation.

He would rather invest the saved money in stocks and hope they pay out more than the interest rate on the mortgage. If his mortgage is cheap enough and extends long enough, seems like sound reasoning to me. If you lock in a low interest rate, it does function as a hedge, should inflation spike.

Paul Solman: Seems like sound reasoning to me too, except the part about putting it all into stocks. Has your friend ever looked at the performance of stocks the last time inflation spiked, late 1960s to 1981?

Boston University finance professor Zvi Bodie takes a sterner view. Though you’ll see he’s pushing his own books, you can be sure it’s not to make an extra buck or two. Having followed his own investment advice, he’s well provided for. Not saying he’s necessarily right this time, but he fervently believes in the advice he’s been pushing — and pushing for years.

Zvi Bodie: Instead of sound reasoning, I would call this strategy “fool’s arbitrage.” It rests on the fallacy that stocks will always outperform bonds (and mortgages) in the long run. Fool’s arbitrage is responsible for the massive underfunding of state and local pension plans. To understand what the fallacy is, I recommend reading “Worry Free Investing” and the soon-to-be -published “Risk Less and Prosper: Your Guide to Safer Investing.”

An excerpt from chapter five of the new book, called “The Allure of Hope”:

Our minds are not built … to work by the rules of probability, though these rules clearly govern our universe.
–Stephen Jay Gould

The credo of stocks-for-the-long-term owes its currency not just to outside influence but also to our cognitive makeup. We have been willing collaborators in deception. Emotion biases our perceptions, coaxing us to take the bait at nearly every turn. We humans are simply not wired well for judging risk.

Riddles of Randomness
A common device for touting the superiority of stocks in the long run is to chart historical U.S. stock returns over very long terms. Lengthy tables like these are used to show that over very long holding periods (of 60 to 100 years), the average inflation-adjusted return on stocks is quite steady, hovering around 6.5 percent.

Many people take assurance from these numbers. But they interpret the very long-run historical record much too narrowly, expecting to earn a real rate of return close to 7 percent — as long as they hold on for a while. When they subscribe, in principle, to the long-term nature of the engagement, they seldom reflect on how the long horizons fit their own circumstances.

But there are plenty of 20-year periods when U.S. stocks returned a lot less than 7 percent. The Great Depression is perhaps the most extreme example. An investor who bought stocks at their peak valuations before October 1929, and then held on, might not have lived long enough to find out. That investor would not even have recouped all losses, in real terms, until around 1950.

Even excluding the wild losses of the Great Depression, there are other instances when 20-year average annual returns fell below the returns on bonds — or even came close to zero. If you’d bought a broad stock index or its equivalent in 1965, it would have taken a full 18 years until you saw any positive real return. The inflation and market collapse of the 1970s were that severe.

At the end of 2010, the 20-year average annual real return of the broad stock market was closer to 4 percent than to 7, and a year earlier it was lower still.

Or, consider Japan. In the 1980s, Japan was in the ascendant. Its car makers, electronics companies, and even its banks were seriously challenging their American rivals. Japanese property values were soaring. And the Japanese stock market was sky high after many years of extraordinary growth. In 1989, Japan’s broad large-company stock index, the Nikkei 225, peaked at around 40,000. Today the Nikkei index is valued below 10,000. A Japanese retiree relying on the stock market in 1989 would have been even worse off than his U.S. counterpart in 1972.

Still, the promise of a continuous, steady return exerts a kind of magical charm. The assumption that the expected return will be one’s own return is hard to resist. Partly this is because most people understand the lean years of the past as unique and nonrecurring–the results of either very high inflation or the Great Depression. Partly, too, it’s been the education of several decades that robust returns swallow up the bad years in the long term.

This entry is cross-posted on the Rundown- NewsHour’s blog of news and insight. Follow Paul on Twitter. Image at top by flickr user nikcname via a Creative Commons license.