Investing Advice

Another semester has gone by, and I'm that much closer to finishing my Ph.D. program. I've only got one more semester of doctoral coursework left, and then next year I'll have to take 6 MBA courses to be completely done with classes for the rest of my life. After that, I'll just have to write a dissertation to be done! No sweat, right? :)

Anyway, it was a great semester. Not only did I get my best grades so far at Harvard (woohoo!), but I felt like I actually learned lots of useful stuff. Even better, a couple of the things I learned might even be useful to non-economists as well. You see, before this semester, people often asked me about when to put their money in the stock market and other such investing questions, but I didn't really know that much about investing so I always felt like I wasn't qualified to say much. This past semester I had a whole class on asset pricing, which made me feel slightly more competent in answering this type of question. So I thought I'd pass along a few tidbits that might be of interest.

***DISCLAIMER 1***

This is a nerd post. I think it's a useful nerd post because it gives some advice on how to manage your money. But it's still a nerd post. Don't feel obligated to read it.

***DISCLAIMER 2***

What you are about to read is based on historical data. When predicting stock prices, the best anyone can do is use historical data (and economic theory) to forecast future movements, but it is impossible to perfectly predict the market. In fact, even the best investment managers aren't all that accurate with their predictions. Investing (in any market) is always risky. My advice is just some broad generalizations that have proven to be good ideas in the past. That doesn't mean you will automatically make money if you follow it.

Okay, with that out of the way, here are 4 tips on managing your money:

1. The stock market is predictable: How many of you have always been told that you can't predict the market? I know I have been told that lots of times. To some extent it's true. If you're trying to predict whether the market will rise or fall tomorrow, you've got about a 50/50 chance of getting it right. But here's the thing: the market is predictable at longer horizons, say, 3-5 years. How can you predict it? By using a financial ratio like the price-earnings (P/E) ratio. The idea behind these ratios is simple. If stock prices are really high relative to how much a company is earning, then you'd guess that the price is going to come back down. In the long run, these ratios are mean-reverting. If the P/E ratio is too high, it's because either (a) prices are too high or (b) earnings are going to rise a lot in the future (they are too low right now). Historically, earnings are pretty stable, so the answer is nearly always (a). Thus, if the P/E ratio is a lot higher than its average value, you can expect stock prices to fall over the next 3-5 years. So, if you're looking for a good time to put more money in the market, check out the P/E raito. If it's high, I'd wait a while. If it's low, maybe it is a good time to put some money in. Lucky for all of us, a financial economist from Yale (Robert Shiller) collects this data and puts it on his website here (download the excel file in the paragraph that says "Stock Market Data", then look at figure 1.3 in the excel file). Right now, the P/E ratio is 20.12, a bit over the historical average. So, at the moment, I'd call it a neutral market.

It's important to remember that you are looking at a longer horizon. Just because the P/E ratio is low today, that doesn't mean it won't go lower before it comes back up. That means that you might see a low P/E ratio, put money in the market, then lose money as prices fall even further before they come back up again. Sometimes you have to ride these times out before you make money. In other words, don't try to use the P/E ratio to predict where the market will be one year from now; it doesn't work. And, if you're looking for a quick place to make money, don't try the stock market.

I also want to point out that these financial ratios account for only about 60% of long-term stock price variation. That means that the other 40% could go any which way. 60% is pretty good, actually (way better than the 0% you get when trying to predict the market tomorrow!), but there is obviously still some risk involved in these bets.

2. Diversify: I'm hoping that everyone has heard that you have to diversify. Unless you are a professional investment manager, the most effective way to diversify is to invest in stock market indexes like the S&P 500 or the Russell 2000, which allow you to buy 500 or 2000 stocks all at once. There are also indexes for particular sectors of the market (e.g. financial indexes, technology indexes, manufacturing indexes, etc.). Picking individual stocks that you think are going to do well is generally not worth it, in my opinion. If you have a lot of time on your hands, you could try to do it, but it's much riskier and very hard to do.

One way to diversify that people might not think about as much is to put less of your money in the industry you work in, particularly in your own employer if you work for a public company. For example, say I worked for Enron in 2000. If I had put all of my retirement in to Enron stock (as many Enron employees did), I would have lost my job and my entire retirement by 2002. Bad idea. Another, less extreme, example: Say I work for a financial company. It would be smart to put less of my money in financial stocks since when those stock prices go down I am also more likely to lose my job, take a pay cut, or get a smaller bonus. By diversifying away from your job, you protect your wealth a bit better.

3. Rebalance: Let's say you take a look at the P/E ratio and it's relatively low (say, 13) so you increase the portion of your retirement wealth in the stock market from 50% to 60%. To keep things simple, let's say that the you've got the other 40% in a savings account (in reality, you'd probably have most of it in bonds or other such investments). Now suppose that stock prices drop even further, so that the P/E ratio is now at 10. Do you still have 60% of your portfolio in stocks? No. Since stock prices have fallen, that portion of your portfolio is worth less than before, so you now have less than 60% in stocks. What should you do? Take even more money out of your savings account and put it in the market to get back to (at least) 60%. You might even want to put more than 60% in the market since the P/E ratio is even lower than it was before. This process is called rebalancing. This is hard for many people to do; if you've just lost money in the stock market, it's hard to want to put more in. But that's exactly when you should be putting more in, since the investment opportunity is even better.

4. Refinance: I was surprised to learn in my class that many people fail to refinance their mortgages when mortgage rates drop well below their current rate. It's worth it to check out mortgage rates from time to time to determine if you should refinance. A good rule of thumb is to refinance when current mortgage rates are 1% lower than the rate you pay. Over time, you can save a lot of money just by paying a little bit of attention to mortgage rates.