Bryan Caplan Believes in the Equity Premium Puzzle

He not only believes in it, he believes in the home bias puzzle too--and he acts on his beliefs:

EconLog, Four Bad Role Models, Bryan Caplan: Library of Economics and Liberty : Karen Lewis' excellent article on home country bias in the Journal of Economic Literature convinced me that I should drastically increase my ratio of international assets to domestic assets. After a brief "cooling off" period imposed by my ever-prudent wife, we went forward and made the change.

But has he mortgaged his house to the gills and invested the proceeds in international equities? Enquiring minds want to know!

Comments

[anne]

http://select.nytimes.com/2006/03/04/business/04nocera.html

March 4, 2006

The Anguish of Being an Analyst
By JOE NOCERA

YOU never know what's going to set someone off. Consider the case of Michael Mayo, who runs the financial services research team for the Prudential Equity Group.

Mr. Mayo, 42, is one of the few Wall Street analysts who is willing to put sell recommendations on stocks when he thinks it is warranted. Starting in the spring of 2005, he had a sell rating on J. P. Morgan Chase. But in early January, Mr. Mayo upgraded that to hold, and on Jan. 31, he went all the way to buy.

As it happens, that was the day that J. P. Morgan's chief executive, James Dimon, was delivering a speech at a big investment conference. There were more than 500 people in the room — hedge fund guys, mutual fund managers and other institutional investors that analysts cater to — "the 500 people who butter my bread," as Mr. Mayo later put it.

Mr. Dimon opened his remarks by noting the upgrade by Mr. Mayo, who, he said, "has had both J. P. Morgan Chase and Bank One on his sell list for probably 10 or 15 years." (Mr. Dimon took over Bank One a few years before it was acquired by J. P. Morgan in 2004.) "So I called him up," Mr. Dimon continued, "I said, 'You know what? First of all, I would like to prove you right, but you have been wrong for so long I hope it is a good omen that you have us on your buy list.' "

In the scheme of things, this is hardly the worst thing a chief executive has ever said about a securities analyst. Mr. Dimon is not known for being vindictive or retaliatory toward analysts; people who work for him say that he is unruffled by sell ratings. Indeed, he believes they are a healthy part of the capital markets, and he viewed his remarks about Mr. Mayo as good-natured. When he later learned that Mr. Mayo was upset, he phoned him and apologized. "Dimon has a great deal of respect for Mike Mayo," a J. P. Morgan spokesman told me.

But there was something about the incident that stuck in Mr. Mayo's craw. Joke or not, he felt that Mr. Dimon had maligned his stock-picking record in front of the very people who sent trading commissions to Prudential in return for his research. And apology or not, there was nothing he could do about it. "It just crystallized to me that there is no recourse for analysts," Mr. Mayo said.

He's right about that. Which may help explain why three years after the New York attorney general, Eliot Spitzer, supposedly cleaned up Wall Street research, buy recommendations still vastly outnumber sells — and most analysts still spend far more time currying favor with companies than analyzing them.

When you think about it, the whole point of Mr. Spitzer's investigation into research — an investigation that resulted in $1.4 billion in fines, a new set of rules regarding analyst conduct, and the singling out of two analysts, Jack Grubman and Henry Blodget, for their bad behavior — was to make the profession honest again....

[anne]

On paper increasing holdings of international stocks may make sense, even a drastic increase may make sense, but there are problems psychological or practical. Japan is the stock market that accounts for about 75% of the Pacific index, and the heaviest proportion of shares in international indexes. But, Japan is in the midst of what may be the fiercest bear market of the century. The Nikkei index climbed to 38,900 in 1989, and is below 16,000 today with almost no dividends to make up the difference and no currency strengthening that would make up the difference. Care to buy Japan?

[Robert Waldmann]

hedging Brad hedging. The expected return on his house might be low or negative, but the return on his house perfectly matches his personal housing deflator (assuming he isn't moving anywhere).

[Robert Waldmann]

hedging Brad hedging. The expected return on his house might be low or negative, but the return on his house perfectly matches his personal housing deflator (assuming he isn't moving anywhere).

[anne]

So, then take a 30 year mortgage against your home, along with the tax break, and invest in the REIT index which has an adjusted dividend of 3.74% and provided you can afford the difference in payments assume there will be capital gains enough to make the investment worth while in time, not to mention the appreciation in price of your home :)

[Jonathan Goldberg]

Anne asks:

The Nikkei index climbed to 38,900 in 1989, and is below 16,000 today with almost no dividends to make up the difference and no currency strengthening that would make up the difference. Care to buy Japan?

If I knew things like that I'd be smart. Blood on the streets. That's the time to buy, right?

[anne]

There has surely been "blood on the streets," but investors can be a peculiar lot and rather avoid bargains unless they are the sort of bargain that makes a $600 Manolo a must buy at $550 :) And, the Japanese market is awfully peculiar in addition.

[wcw]

Whether you mortgage your house is a question of how much you have to lose. If you're wealthy (and I mean actually wealthy, not a dime-a-dozen, 90%-mortgaged, $100k-a-year coastal homeowner who thinks he's rich because Zillow says his house is worth $1.5 mil), go for it. If you're one of the rest of us, given the negative NPV of retirement and childrearing expenses, your balance sheet has such heavy liabilities that you have little if anything to lose and should be very, very conservatively positioned.

On home bias, it's always baffled me. Do you believe in indexing? Then to have a home bias is to invest as if you didn't, since you're deviating from index weight on 40% of global capitalization. Do you market time? Then to have a home bias is to assert that for some reason the proper weight for this huge chunk of investment options will always be zero.

Both poses strike me as more than usually insane, even for us more-than-human investors.

[anne]

Since a home bias would have worked nicely, if you please, for the last 60 years, and since international index investing is only fairly recently become convenient, I am content knowing an investor has a home bias, though there are fine opportunites internationally. When I can find an analyst who understands valuations in Japan, or the 16 year bear market, I may even be interested in giving over more of my own mild home bias :)

[anne]

What might be found when 2004 and 2005 returns are analyzed is that there is a slight bulge above 22% in proportion of income as taxes paid by households from about $150,000 to $350,000. The effect of the Alternative Minimum Tax is curious in incidence. But, we are remarkably flat taxed. Remember, there are other sources of government revenue than household taxes.

I would add, "not that there's anything worng with that," but though fun I am not sure it is appropriate :)

[Maynard Handley]

"
But, Japan is in the midst of what may be the fiercest bear market of the century. The Nikkei index climbed to 38,900 in 1989, and is below 16,000 today with almost no dividends to make up the difference and no currency strengthening that would make up the difference. Care to buy Japan?
"

*IS IN THE MIDST OF*? Japan rose what, 16% last year?
Sure, if you'd invested in Japan in 1989 you'd be upset. But if you invested in Japan last year, or the year before, or the year before that, you're probably not doing too badly.
The Japanese fundamentals are an educated hardworking workforce and no real social problems. Against that we have a political system that no-one seems to understand. Biased either way we have demography (which will lead to more old, fewer young, sure, but will probably also lead to serious R&D into products the rest of the world will want to buy before the US and perhaps Europe --- vide personal robots and hybrid autos.)

To me Japan flashes "sell sell sell" way less than the US.

[anne]

I neither suggest nor do not suggest Japan, but I would class the Japanese market from 1989 as easily the most dangerous, most poorly performing, of any developed country market in 60 years. And, I surely do not begin to understand the market valuations :)

The 15 year return is about 0, the 10 year return is 0.4% while the 5 year return is 7.1%.

[anne]

The Japanese bear market did notably little damage to individual Japanese investors, by the way, because Japanese households invest very little in stocks. Japanese financial companies, and international finance companies in Japan, are decidedly investor unfriendly, and there is almost no pressure on Japanese companies to pay attention to stock prices.

[meno]

anne,

Japan's had a big bear market for 16 years (with a few variations).

The USA's had a big bull market for 25 years (with a few variations).

You strongly prefer investing in one t'other because you think you know better than the markets which is going to do well.

But the point about diversifying globally by buying into a set of global index funds is that you suspend your attempts to outguess the markets and you spread your investment onto both options - and onto the rest of the world as well. Diversity is investing by humility. And the meek shall inherit.

Also while Japan is 40% of the pacific index, that's not all the pacific index, and the pacific index isn't all the global market. Investing in global stocks != investing in Japan, it's much more than that. Oz and NZ have been doing very nicely, thanks. India's looking very interesting. Et Cetera.

[but first I'm paying off my mortgage]

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Meno, nicely argued :) though Japan is 76.3% of the Pacific index. The dominant countries of the emerging markets index are Korea, Taiwan, Brazil, South Africa and China, which make up about 70% of the index. India is only 6.5%. But, you can tell by my hedgy remarks that true indexing requires true discipline.

[ephedra diet pill]

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