Where Economists Put Their Money


Fortune issue: June 8, 1998

First Principles


Where Economists Put Their Money

By N. Gregory Mankiw

One of the occupational hazards of being a professional economist is that every now and then, friends and relatives ask for your opinion on the stock market--usually whether it's going to go up or down. Fortunately, that's an easy question: I have no idea. I promptly explain my ignorance with the famous random-walk hypothesis, which holds that the best guess about tomorrow's stock price is today's stock price (plus a bit of upward drift to reward patience and risk taking).

What's embarrassing is not being asked to predict the future but being asked to explain the past. Why have stock prices doubled in the past three years? I couldn't tell you. What's worse, I have no theory to tell me why I can't. According to the random-walk theory, stock prices should move in response to news about the value of the underlying companies. And while such news may be impossible to forecast, you'd think it would be possible, with the benefit of hindsight, to identify the news that moves the market. Well, it isn't: Even after the fact, stock prices are often a puzzle. No one can credibly claim, for instance, that the modestly good news about growth and inflation over the past three years explains the stock market's huge surge during that time.

Rather than asking economists to predict movement of the stock market, it is better to ask them what they are doing about it. So at a recent conference of economists from the nation's top universities, I informally polled my colleagues about their own portfolios. Laymen call this putting your money where your mouth is; economists call it "revealed preference." The answers to my poll were revealing indeed.

One group of economists had almost everything in equities. They noted (correctly) that stocks have historically outperformed cash and bonds by a large margin--about six percentage points per year. Stock prices are close enough to a random walk, they argued, that timing the market--moving in and out to profit from short-term fluctuations--is a fool's errand. Better to buy and hold.

A second group had almost nothing in equities. They noted (correctly) that historically, when stock prices have been high relative to fundamentals such as earnings or dividends, subsequent returns have tended to be low. They pointed to Japan, where the market today is still at less than half the peak it reached a decade ago, and to the U.S. in the 1930s, when stock prices plunged 90% over a few years. Better safe than sorry, they said.

One famous economist told me that he used to be a market timer but has since kicked the habit. During a previous market run-up, he got out of stocks and waited for the "inevitable" downturn. But he wasn't sure exactly what he was waiting for. A 10% correction? A 30% bear market? He gave up trying to decide and became a buy-and-holder.

As for me, I fit into neither group. I keep a constant 60% exposure to equities, rebalancing as needed. I buy a bit when prices fall and sell a bit when prices rise, which makes me feel as if I'm doing something, but not too much. I can't gloat like my more aggressive colleagues, but I've avoided most of the regrets of the market-timers. Of course, that does mean I keep 40% of my portfolio in cash and bonds (including the Treasury's new and attractive inflation-indexed bonds), and that might tempt you to ask me what will happen to interest rates. But being asked to predict interest rates is another occupational hazard--one I'll save for another day.


N. GREGORY MANKIW is a Harvard economics professor and author of Principles of Economics.