Tim Harford – On The 8 Spot

Tim Harford, author of ‘The Logic of Life‘ and ‘The Undercover Economist‘, advocates borrowing money to start investing in the stock market.

Here are the chief investment lessons of the financial crisis for today’s young people: they should be buying more shares and running up debts to do so. I’m not saying that the market is undervalued… I am merely suggesting a way of reducing risks.

Arguing that holding stocks in the long term is not guaranteed to be particularly safe, he goes on to describe the effect of “generational risk”:

…stocks can be very volatile. We also know that some generations have been luckier than others when it comes to the performance of the stock market. The baby boomer who started regular purchases of US stocks in 1970 and sold up in 2000 would have felt pretty sick after the awful bear market of 1974, but in retrospect his timing would have been perfect, filling his boots with bargain late 1970s and early 1980s shares, and selling out right at the top. His daughter, entering the stock market in 1995 and aiming to retire in 2025, would have spent the past 13 years buying shares at prices that now seem to range from high to extortionate. We could call this “generational risk”.
Now, think about the current prevailing wisdom on investing in shares, which reflects the fact that shares tend to produce high but risky returns. It is to start by putting most of one’s savings into the stock market, and as retirement approaches, increasingly shifting one’s portfolio to bonds and other less volatile investments. That seems to make sense. In fact, it is nonsense…
…The logical way to fight generational risk is to borrow money to make large, regular investments in shares while young, then use a proportion of later savings to pay back the loan rather than to pile into the stock market in middle age. That sounds risky, but it is in fact exactly what people do in the housing market. Knowing that they will need a place to live all their lives, they tend to buy a small house and gradually trade up to a bigger one, only paying off their mortgages late in life.
Most of us need a retirement fund as well as a place to live; there is nothing intrinsically risky about regular borrowing to get that fund off to an early start.
Not only does the concept make sense, it has paid off in the past. The Yale academics who proposed it, Ian Ayres and Barry Nalebuff, have looked at historical stock market data covering 94 cohorts who retired between 1913 and 2004. For every single cohort, the early leverage strategy beat the conventional wisdom; it also almost always beat the gambler’s strategy of investing every penny in stocks until the moment of retirement. Only the blessed cohorts who retired in 1998 and 1999 did better. Such gambles rarely pay off, so if you’re 20 years old and want to spread your risks, mortgage your retirement today.

It makes sense in a way that I’d rather invest a large position (funded by debt) in stocks while young and ‘throw the key away for 20 years ‘ (like Warren Buffett‘s long-term value investing. This is better than starting with a small position then personally trading up to have a large position in 20 years. Think of the time and energy this will entail! I don’t want my mind usually thinking of the stock market, with all of its ups and downs.
On another thought: Does anyone know how this is possible in the Philippine banking industry? If I can fund stock market purchases via credit card, I MIGHT consider getting a credit card (which I have no plan of getting ever).

A father writes Tim Harford (author of the book Undercover Economist) to inquire on how to divvy up a stash of cash as incentives for his son to pass his exams. Harford answers:

Start by promising more than you can deliver. If you offer €10,000 for a perfect score, you will only need to apologise after your scheme has succeeded. That may seem to undermine your credibility, but the real risk lies the other way: your son may expect to get the money from his doting dad anyway. Discourage this view or your plan will be in vain.
You must also pitch the stakes just right. Research in behavioural economics suggests that trivial rewards are worse than no rewards, but also that performance suffers when too much is at stake.
Finally, focus on the early exams, because success breeds success. Promise your son €200 for every excellent result in these: that should engage his interest without throwing him into a panic. If things go well, the money will run out before the high-pressure exams. But by then he will have mastered his subjects anyway.
Link

Now, the question here is can we develop an insurance scheme that will fund the incentives (drawing from the insurance policy)? In the payment term, parents would be pressed to help their child (via tutoring). In the long run, (in the ideal case) the child will have enough study habits and have high enough grades to qualify for college scholarships.
On the other hand, the child may be put off by the hard work involved with studying which will increase the lure of those ‘get-rich-quick’ schemes when he gets older.

Tag: Tim Harford

Tim Harford: Borrow Money to fund Stock Market Investments

getting paid to study (incentives for exams)

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