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Investments for the Young

June 22, 2008

I ran across a paper that is quite interesting while on the blog Nudges, a blog I frequent.  Most of the folk wisdom surrounding how much money to allocate to stocks and bonds in your retirement portfolio use simple rules of thumb such as “the percentage of your assets in stocks should be 110 minus your age.” In other words, if you are 30 years old you should hold about 80% of your portfolio in equities. This paper explored the accuracy of these common rules using historical data on stock and bond returns and finds that they typically produce portfolios that are far too conservative for younger workers. Younger workers should essentially hold all of their retirement portfolio in stocks, and should even borrow to buy those stocks if they are able to do so.

 

Even though the authors are probably giving us some very good advice, I suspect people will resist this kind of information because one well-ingrained and often-repeated mental heuristic for dealing with money is “don’t put all of your eggs in one basket.” Even if this bit of folk wisdom is meant to advise people against concentrating their money in a single asset (i.e. the stock of a given company) rather than in a particular asset class (i.e. equities), for many people it would still feel like they were violating some kind of sage rule of investing. It is difficult to overcome this neuroeconomic reaction, even if it flies in the face of demonstrably good advice.

 

The reason this problem is particularly interesting to me is because one of the consistent patterns we see in individual portfolio data is that many people, but particularly those of more modest means, do not hold enough equity. This is one reason why the poor are particularly at risk for financial shortfalls in retirement (see post “Into the Wild” and “Presidential Candidates Duck Hard Issues on Savings”).

 

Research that reinforces, and extends, our understanding of the benefits of equity ownership from an early age are important stepping stones for constructing sensible public policy. But in so doing we will also need raise our eyes from prescriptions that assume a high degree of economic rationality and consider people’s automatic, or gut level, responses. Only prescriptions that are congruent rather than contradict these basic instincts are likely to be successful.

 

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2 comments

  1. I think many people (especially more recently) feel the “don’t put all your eggs in one basket” argument might apply to the stock market as a whole. While historically the stock market performs well in the long term, I think there is a sense that these are extraordinary times (post 9/11, an energy crisis, war, etc…). And because of this uncertainty and the oft-repeated mantra “past performance is not a guarantee of future returns” people may not want to rely on the stock market.


  2. I think there three issues involved in investment options for the young.

    1. what type of account should the investment be in. An IRA (if the child has earned income), an account in their own name, an Ugma account or a 529 type account. Perhaps even savings bonds.

    2. An investment can be a learning expirence. Teach while you invest.

    3. The stock market with mutual funds or even gifts of stock seem an obvious choice. Yet corporte bonds can also be purchased with no commissions and can offer 7 -8 % annual returns that be even tax free.



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