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401k Plan Sponsors Beware: Are You Lighting a Match in the Powder Room Despite 1995 Study?

October 08
00:12 2010

(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

In the classic Looney Tunes scene, the pirate Yosemite Sam traps our hero, Bugs Bunny, in the powder (as in “gunpowder”) room. Sneaky Sam then proceeds to throw a lit match into the room and plugs his ears in anticipation. When nothing happens, 292185_2932_powder_room_stock_xchng_royalty_free_300he charges in to see dear ol’ Bugs powdering (as in “talcum”) his nose in what appears to be a daintily outfitted washroom. Bugs blows out the match and leaves, locking Sam in the room. When Sam lights a match to find his way out, he discovers the room has transformed itself back into a gunpowder storage area. Poor Sam made the mistake of placing more credence on what he had just seen than on what’s the more likely reality. The show ends with a bang.

Will 401k plan sponsor’s failure to heed the warnings of the 3rd Deadly Sin of ERISA fiduciaries end with a bang?

The Old Rule of Bond Investing: Bonds offer security by Reducing Portfolio Volatility

So, let’s review our definition of a risk-free bond. To eliminate any complicating (and misleading) factors, we have defined a pure bond as one that: must have a certain maturity (i.e., the issuer cannot call it prior to the original maturity date); must be issued by the U.S. Treasury (so we can eliminate any of the noisy risks so common in the real-world but never found in any theoretical discussion); and, must have a long-term maturity (in other words, we do not want to confuse cash and bonds as being the same thing).

Traditionally, a pure US government bond portfolio has been used to meet the Safety of Capital investment objective. In return for ensuring Safety of Capital, the bondholder would receive a fixed income. Besides producing income, bonds have traditionally been used to reduce volatility within an investment portfolio. Indeed, no less an authority than Ben Graham, in his Intelligent Investor, explains the role bonds play in reducing volatility in an investor’s portfolio. In a sense, bonds offer the same consistent security the farmer enjoyed when he went to work in the factory (see Part I of this series: “How the Fiduciary can Explain the Practical Differences Between Stocks and Bonds”).

What’s Wrong with This Sin?

As early as 1997, even the Wall Street Journal began to question the Old Rule of Bond Investing. The article made a point long held by experienced investors – investing for purely social reasons does not generally produce pleasant investment results. Still, the author wondered, why do these well-to-do hippies continue to flail themselves against this Holy Grail? In an aside that speaks louder than the article’s main topic, the writer likens social investors to people who invest in bonds or money-market funds. These investors, claims the article, fall under the mistaken understanding bonds and money-market funds somehow offer greater safety than stocks. “Over the long term, though, such investments really aren’t safer. In the short term, stocks are extremely risky. But if you hold them for 10 years of more, they are not much riskier than bonds – and they return, history shows, an average of 11% annually.” (“Why ‘Socially Conscious’ Investments Don’t Pay Off,” Wall Street Journal, March 26, 1997)

Indeed, academics have long been interested in the reasons behind this little snippet. After all, finance professors have weaned an entire generation of MBAs on the very proper concept that one must receive some just compensation for the risk taken. Why, then, should equity investors earn a premium over and above what one might expect given the amount of risk taken. (By the way, academics tend to refer to stocks as equities. Who knows why? Perhaps they feel term “stocks” reflects a too plebian aura.) By the mid-1990’s, this divergence between the real world and the theoretical world of Modern Portfolio Theory became too big to ignore. Writing in the staid Quarterly Journal of Economics (Vol. CX, Issue 1, February 1995, Pages 73-92), two members of the ivy-covered fraternity (Shlomo Benartzi and Richard H. Thaler) began to step ever so gingerly into the sights, sounds and dimension some had been tempted to call “Post-Modern Portfolio Theory” but most now recognize as “Behavioral Finance.” They titled their article “Myopic Loss Aversion and the Equity Premium Puzzle.”

Benartzi and Thaler explain the puzzling tendency of stocks to offer better investment returns than bonds actually began more than a century ago. (Of course, the term “Equity Premium Puzzle” has only been around since 1985, courtesy of two other fellows named Mehra and Prescott, but let’s not quibble.) In fact, nearly seventy years of data, as compiled by Ibbottson, shows stocks return, on average, about 6%-7% more than bonds. Everyone knows this. (If you don’t, you should.) Here’s the real puzzle Benartzi and Thaler tried to solve: If everyone knows stocks perform better than bonds, why doesn’t everyone invest in stocks and forsake bonds. They proposed “a new explanation based on two behavioral concepts.” First, they assumed investors are “loss averse.” Someone who has an aversion to losses tend to derive greater unhappiness from losses compared to the happiness caused by gains. Moreover, Benartzi and Thaler assumed all investors (even self-proclaimed “long-term” investors) appraise their portfolios often. They named the combination of these two assumptions “myopic loss aversion.”

The two conducted simulations and discovered they can fully explain the Equity Premium Puzzle if investors look at their portfolios on an annual basis. In other words, the pain they feel when stocks lose money in one year far exceeds the joy they know they’ll feel seeing the gains they’ll receive by holding those same stocks for several years. Here’s how it works. Let’s say people don’t like losses. Let’s also say you’ve got a better chance of experiencing a loss in your portfolio over short-term intervals versus long-term intervals. Heck, let’s throw some numbers in. Let’s say for every ten times you look at your one-year returns, four of those years will show a loss. Now let’s say for every ten times you look at your ten-year returns, you’ll only see one loss.

So, you get sick every time you see any loss. Really sick. If you constantly look at one-year returns, over the course of ten years, you’ll be sick for four of those years. Now, if you only look at the ten-year returns for that same portfolio, chances are you’ll only be sick for one year. (You still with me here? This is important.) So, what do you do if you feel sick? You change something. For example, if you’ve got a cold, you may change how much Vitamin C you’re taking (specifically, you may take more Vitamin C). Likewise, if your portfolio makes you feel sick, chances are you’ll change something in your portfolio.

Change your portfolio? Just because you accidentally looked at one-year returns instead of ten-year returns? Yes, and what do most loss-averse investors buy when they want to reduce the chances of a one-year loss in their portfolio? They buy bonds. So, as a result of this short-sighted loss aversion, investors buy more bonds than logic would deem appropriate (at least in terms of historical rates of return). Don’t laugh. As much as you’d hate to admit it, you’d probably make the same mistake.

Now here’s the real kicker. Benartzi and Thaler did not just employ sophisticated game theory simulations on some super computer. They used real people and asked them to allocate their real retirement investments between stocks and bonds. Our two boys (economists masquerading as psychologists – or is it the other way around?) found they got very different answers depending on how they framed the historical data. If Bernartzi and Thaler presented people historical data containing 30 one-year returns, those people allocated, on average, roughly 40% of their retirement assets to equities. If those same people saw historical returns containing thirty-year returns, their equity allocation jumped to 90%!

This same experiment has been repeated several times and the results have been confirmed. Indeed, this experiment has become a favorite parlor trick among not only leading edge finance professors, but also among those financial professionals who embrace the techniques of Behavioral Finance.

But wait! There’s more! Sure, we can explain why otherwise smart people invest in bonds. And, yes, by destroying the myth of the rational investor, Benartzi and Thaler’s work ranks as one of the more important studies in the world of behavioral economics. Yet, that explanation still requires us to buy into the presumptions that bonds are safer than stocks. And we do not merely refer to Siegal’s 1994 analysis that, over long periods of times, long-term bonds (that pay a fixed amount in nominal terms) are actually more risky than stocks in real terms, (primarily due to the long-term wealth erosion effects of inflation). No, we mean to strike at the very heart of the bond myth: that bonds experience less volatility than stocks. But before we go on, we must repeat the most important historical truth for the preceding exercise: Stocks have regularly performed better than bonds.

Part I: How the Fiduciary can Explain the Practical Differences Between Stocks and Bonds
Part II: Defining the Perfect Bond: What Every Plan Sponsor Must Know About Bonds – Before They Crash!
Part III: 401k Plan Sponsors Beware: Are You Lighting a Match in the Powder Room Despite 1995 Study?
Part IV: Will Plan Sponsors Believe Their Lying Eyes or Will They Still Believe Bonds are “Safe”?
Part V: How the ERISA Fiduciary Can Avoid the 3rd Deadly Sin – Bond Insecurity

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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