Naked Economics by Wheelan, Charles (spanish books to read .txt) 📕

26.5 percent of its value in its worst year; the bond portfolio never lost more than 5 percent of its value in a single bad year. Similarly, the stock portfolio had negative annual returns eight times between 1945 and 1997; the bond portfolio lost money only once. The bottom line: Risk is rewarded—if you have a tolerance for it.

That brings us back to the Harvard endowment, which lost about a third of its value during the 2008 financial crisis. And Yale lost a quarter of its endowment in one year alone. Meanwhile, over the same stretch of dismal economic circumstances, my mother-in-law earned about a 3 percent return by keeping nearly all of her assets in certificates of deposit and a checking account. Is my mother-in-law an investment genius? Should Harvard have directed more of its assets to a giant checking account? No and no. My mother-in-law always keeps her assets in safe but low-yielding investments because she has a small appetite for risk. She is protected when times are bad; of course, that also means that if the stock market posts an 18 percent gain one year, she earns…3 percent. Meanwhile, Harvard and Yale and other schools with large endowments earned enormous returns during the boom years by taking large risks and making relatively illiquid investments. (Liquidity is the reflection of how quickly and predictably something can be turned into cash. Illiquid investments, like rare art or Venezuelan corporate bonds, must pay a premium to compensate for this drawback; of course, when you need to get rid of them quickly to raise cash, it’s a problem.) These institutions pay an occasional price for their aggressive portfolios, but those bumps should be more than offset in the long run with returns that are a heck of a lot better than a certificate of deposit. Most important, the endowments are different than the typical investor planning for college or retirement; their investment horizon is theoretically infinite, meaning that they can afford some really bad years, or even decades, if it maximizes returns over the next one hundred or two hundred years (although both Harvard and Yale have had to make serious budget cuts lately to make up for lost endowment revenue). Yale President Richard Levin told the Wall Street Journal, “We made huge excess returns on the way up. When it’s all over and things stabilize I think we’ll find the overall long-run performance [of the endowment] is better than if we didn’t.”12 I suspect he’s right, but that doesn’t necessarily make it a wise strategy for my mother-in-law.

Diversify. When I teach finance, I like to have my students flip coins. It is the best way to make certain points. Here is one of them: A well-diversified portfolio will significantly lower the risk of serious losses without lowering your expected return. Let’s turn to the coins. Suppose the return on the $100,000 you have tucked away in a 401(k) depends on the flip of a coin: Heads, it quadruples in value; tails, you lose everything. The average outcome of this exercise is very good. (Your expected return is 100 percent.)* The problem, of course, is that the downside is unacceptably bad. You have a 50 percent chance of losing your whole nest egg. Try explaining that to a spouse.

So let’s bring in some more coins. Suppose you spread the $100,000 in your 401(k) into ten different investments, each with the same payoff scheme: Heads, the investment quadruples in value; tails, it becomes worthless. Your expected return has not changed at all: On average, you will flip five heads and five tails. Five of your investments would quadruple in value, and five would become worthless. That works out to the same handsome 100 percent return. But look at what has happened to your downside risk. The only way you can lose your entire 401(k) is by flipping ten tails, which is highly unlikely. (The probability is less than one in a thousand.) Now imagine the same exercise if you buy several index funds that include thousands of stocks from around the world.† That many coins will never come up all tails.

Of course, you better make darn sure that all those investments have outcomes that are truly independent of one another. It’s one thing to flip coins, where the outcome of one flip is uncorrelated with the outcome of the next flip. It’s quite another to buy shares of Microsoft and Intel and then assume that you’ve safely split your portfolio into two baskets. Yes, they are different companies with different products and different management, but if Microsoft has a really bad year, there is a pretty good chance that Intel will suffer, too. One of the mistakes that compounded the financial crisis was the belief that bundling lots of mortgages together into a single mortgage-backed security created an investment that was safer and more predictable than any single mortgage—like flipping one hundred coins instead of just one. If you are a bank with one mortgage loan outstanding, it could go into default, taking all of your capital with it. But if you buy a financial product constructed from thousands of mortgages, most of them will be fine, which offsets the risk of the occasional default.

During normal times, that’s probably true. A mortgage goes into default when someone gets sick or loses a job. That’s not likely to be highly correlated across households; if one house on the block goes into foreclosure, there is no reason to believe that others will, too. When a real estate bubble pops, everything is different. Housing prices were plummeting all over the country, and the accompanying recession meant that lots and lots of people were losing jobs. The seemingly clever securities backed by real estate loans morphed into the “toxic assets” that we’ve been trying to clean up ever since.

Invest for the long run. Have you ever been in a casino when someone wins big? The casino operators are just as happy as everybody else. Why? Because