business

Betting to Win, Place -- and Grow

When scolds and sermonizers denounce gambling on the stock market, pay no heed. A little responsible risk-taking is a good thing

By Christopher Farrell

Remember this TV ad from Discover Brokerage for online trading?

Passenger: You invest online?

Tow-truck driver: Oh yeah, big time. Well, last few years anyway. I'm retired now.

Passenger: You're retired?

Driver: I don't need to do this -- I just like helping people.

Passenger: (Noticing a picture of an island) Vacation spot?

Driver: Actually, it's a picture of my house.

Passenger: It's an island.

Driver: Well, technically it's a country. Weird thing about owning your own country, though, you have to name it.

Outrageous TV ads like this have become emblems of the mass mania in stock speculation that marked the dot-com craze. Lore held that Wall Street was the place to get rich fast.

Now, speculation is getting slammed harder than it deserves these days. It's fun to bet on the stock market, matching wits against some of the brightest minds going, trying to come out ahead in the world's most competitive open bazaar. Some of the commentary against speculation borders on parody, as if it's distressing that individual investors forgot their station in life by trying to hit the jackpot.

Most important, the impulse to gamble is behind the entrepreneurial spirit, the "animal spirits of capitalism" that have launched so many new businesses and technologies. Without gamblers, speculators, and risk-takers, Silicon Valley would still be largely orange groves and Austin a university town.

HAVING IT BOTH WAYS.

  What's more, individual investors who took a flyer on stocks may have acted more sensibly than current lore holds. That's one way to read a recent paper by Meir Statman, professor of finance at Santa Clara University. How Much Diversification is Enough is partly an investigation into the optimum level of stock diversification, which now exceeds 120 stocks, vs. 50 in the mid-1980s, and 20 in the '60s and '70s. By this benchmark, most individual investors own severely underdiversified portfolios.

But do they? In much of his work, Statman respects individual investors as they are, rather than bemoan how they fall short of the economic ideal. Modern portfolio theory assumes that people are risk-averse and that something is wrong if stock-picking investors own less than 120. But Statman argues that most investors are both risk-takers and risk-avoiders. The people who took a chance on a high-flying tech stock often invested regularly in mutual funds in a retirement-savings plan.

The research on risk-taking is instructive. A 1976 government study, Gambling in America, reported that gamblers were more likely to have their futures secured by Social Security and pension plans than nongamblers. Gamblers also held 60% more assets than their nongambling peers. And as University of Chicago economists Milton Friedman and Leonard Savage noted in a classic 1948 paper, while people buy lottery tickets because they aspire to be rich, they purchase insurance as protection against falling into poverty.

LOSING THEIR HEADS.

  The same goes with stock-picking. Statman argues that it's a rational strategy to have a well-diversified core portfolio, say in a 401(k) plan, as downside protection, and to own a handful of stocks in a brokerage account in the hope of striking it rich. Investor portfolios are often like a pyramid. "Risk-aversion gives way to risk-seeking at the uppermost layers as the desire to avoid poverty gives way to the desire for riches," says Statman. "Such investors fill the uppermost layers with a few stocks of an undiversified portfolio, while others fill them with lottery tickets."

Of course, while some speculation is good, actively trading stocks can prove hazardous to individual investors. Trillions of dollars vaporized as speculative fevers cooled during the three-year bear market -- the longest since 1939-41. Many investors have become disillusioned by revelations of systematic abuses perpetrated on clients by major Wall Street firms, from pump-and-dump scams to marketing hype disguised as research. Many grizzled money-management veterans would agree with French Civil Service Minister Michel Sapin when it comes to amateur investors: "During the French Revolution such speculators were known as agitateurs, and they were beheaded."

Finance economists are devising countless studies documenting that individual investors are lousy traders. They hold on to losing stocks for too long, sell their winners too early, follow the advice of TV touts, underestimate their risk tolerance, and overestimate their stock-picking acumen. And many investors placed unusually large bets on individual stocks -- a highly risky strategy.

HEDGE YOUR BETS.

  William Goetzmann and Alok Kumar, economists at Yale University and Cornell University, respectively, looked at 44,000 stock accounts at a large discount broker from 1991 to 1996. They found that more than a quarter of investor portfolios contained only one stock, more than half fewer than three, and, in any given month, a mere 5% to 10% of portfolios held more than 10 stocks. Even more striking: On average, the value of the portfolios was 79% of the owner's annual income.

Sure, Wall Street deserves a major share of the blame, but it's hard to deny that many individual investors acted foolishly with their savings in the '90s. This column has consistently argued that individual investors should focus on building their portfolios around long-term core holdings of low-cost index funds. A well-diversified portfolio reduces investment risk and increases the odds of earning a decent return over time. According to the Vanguard Group, over the 2000-02 period, the U.S. stock market returned a miserable -37%, but the taxable bond market returned a cumulative 33%. Diversification pays.

These days, avoiding risk is all the rage. But some evidence also shows that it's O.K. to take a flyer every once in a while -- as long as your downside risk is hedged. In the near term, this sluggish economy needs more risk-taking, not less.

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

Edited by Beth Belton

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