What Economists Can Teach Us About Investing

by Marc Bastow | May 22, 2013 11:55 am

When it comes to investing, you’d be surprised just how many people are willing to weigh in if you ask them a question. Friends, relatives, business colleagues, even taxi cab drivers have given me their two cents.

Of course, we prefer to look toward the professionals. Many of us hope to glean advice from CPAs, investment managers, popular hedge funds and financial media. But one profession — economist — is a bit of an oddball in that its ranks are plenty familiar with some of the enormous trends affecting the stock market, but not necessarily gifted when it comes to providing specific stock advice.

Harvard economics professor N. Gregory Mankiw says in a New York Times article that while economists have written on the subject of the stock market countless times, he acknowledges his and other economists’ shortcomings as stock pickers[1] despite their pedigree. However, he then goes on to discuss where they might be helpful — namely, in broader concepts that can still help guide investors. Mankiw’s three basic points:

  1. Owning stocks is still your best bet to produce superior returns.
  2. Holding a diversified portfolio provides a buffer to losses.
  3. Investing in foreign stocks is a great hedge to the stock market.

Looking a little deeper …

Mankiw points to a paper published in 1985 by economists Rajnish Mehra and Edward C. Prescott showing that stocks earned, on average, 6% more per year than “safe” assets like Treasury bills. That should tell you stocks are, and will be, the place to be for long-term growth and return.

Given the climate today of 1% to 2% yields on intermediate- and long-term bonds, holding stocks — particularly those with attractive but stable dividend yields — is a critical strategy for retirement investors. You can easily meet that task by investing in stalwarts such as AT&T (T[2], 4.9% yield), Procter & Gamble (PG[3], 3.1%) and Clorox (CLX[4], 3%), to name just a few.

Diversification means shaping your portfolio in a way that minimizes risk by spreading your money across numerous assets — and then keeping up with it periodically by redistributing gains and rebalancing your holdings.

If you own one particular asset or asset class that appears overweighted, take a second look at what you’re investing in and make sure you’re not placing too many eggs in one basket. While Mankiw suggests 5% as a benchmark, this decision is both a matter of personal taste, as well as the type of asset in question — it’s much easier to feel the risk pressure of an overweight in, say, a speculative growth stock than a low-growth mega-cap.

Of course, this also means you want breadth not just across different sectors, but even businesses within those sectors, different asset classes … and importantly, across various geographic regions. Planting all your seeds in the U.S. would’ve borne some tasty fruit in the past few months, but that might not always be the case. Not to mention, investors with exposure to Japan since last autumn would’ve been enjoying a great deal of outperformance compared to their American-focused peers.

If you do want to take a pick straight from the economist’s advice, Mankiw likes the Vanguard Total World Stock ETF (VT[5]) for its low cost and diversification, though you also could go with the iShares S&P Global 100 Index (IOO[6]), which targets global large-caps. The SPDR S&P 500 ETF (SPY[7]) is relegated to just U.S.-based companies, but among those 500 blue-chips are numerous multinationals, which helps provide some international exposure.

Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing he did not hold a position in any of the aforementioned securities.

Endnotes:
  1. acknowledges his and other economists’ shortcomings as stock pickers: http://www.nytimes.com/2013/05/19/business/for-stock-picking-advice-dont-ask-an-economist.html?_r=1&
  2. T: http://studio-5.financialcontent.com/investplace/quote?Symbol=T
  3. PG: http://studio-5.financialcontent.com/investplace/quote?Symbol=PG
  4. CLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=CLX
  5. VT: http://studio-5.financialcontent.com/investplace/quote?Symbol=VT
  6. IOO: http://studio-5.financialcontent.com/investplace/quote?Symbol=IOO
  7. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY

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