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Speculation won't doom younger investors

John Rekenthaler, CFA  |  05 Apr 2022Text size  Decrease  Increase  |  
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COMMENT / Few traditionalists salute the latest investment trends. Brokerage firms create applications to lure their clients into making impulse trades; cryptocurrency platforms promise future; and social-media conversations led to “meme” stocks. Stranger yet has been the appearance of nonfungible tokens, or NFTs.

Such scepticism is warranted. Properly speaking, cryptocurrencies and NFTs are collectibles rather than investments, as they possess no intrinsic value. Unlike stocks and bonds, such assets do not distribute cash. They therefore are worth solely what others will pay. (Technically, this statement also holds for stocks and bonds, but in practice their cash payments establish a floor for their values.) Their values depend entirely upon the kindness of strangers.

To be sure, the expected return for impulse trades and meme stocks is higher today than in the past, thanks to lower transaction expenses. Back in the day, brokerage commissions and stock market spreads devoured traders’ profits. When professors Brad Barber and Terry Odean studied retail investor behaviour in 1998, they estimated that each equity trade cost their study’s investors 2% of their proceeds. In 2022, with brokerage firms offering free commissions and stock market spreads much tighter, that cost has almost entirely disappeared.

Nevertheless, purchases based on emotion are inevitably hazardous. Not only is the investor likely to know little about their acquisition, given the limited information provided by brokerage-company applications and social-media posts, but the enthusiasm that stimulated the purchase can quickly fade if the security performs poorly, thereby leading to a quick sale. Over the long haul, performance-chasing is no way to profit.

U-shaped portfolios

Viewed narrowly, these developments raise concern about the futures of the younger investors who favour such fare. They are speculations, and more often than not, speculations end unhappily. When considered from a broader perspective, though, the upcoming generation doesn’t appear any worse off than its predecessors. There is a quiet advantage to the current market structure.

Young people

To explain: investors frequently prefer “U-shaped” portfolios. They place one prong of their assets in essential securities. Such assets are diversified, predictable, and dull. The second prong provides the thrills. It consists of the investor’s house money, and it is placed in riskier securities that may prove more lucrative. (Other ways of describing the essential versus house relationship are “core and explore” and “core-satellite.”)

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This tendency may clearly be seen with institutional investors, who hold index funds as their essential assets while devoting house monies to idiosyncratic hedge funds or private-equity funds.

Largely neglected are traditional active managers, as they are neither fish nor fowl. They are rejected for the essential role because they charge more than index funds and rejected for the house money role because they are insufficiently adventurous.

Speculation appeals

One explanation for this behaviour is professional. To beat the competition, institutional investors must take some chances. But the other explanation applies equally to individuals. Most people like to speculate. In some way, shape, or form, they like the idea of getting something for nothing – or of outdoing their neighbours. Institutional investors who buy a hedge fund that later becomes legendary will be happier on the job. Such triumphs bring them pleasure. The same applies to retail buyers who got into bitcoin early. They savour the memory nostalgically.

There’s nothing new about behaviour like this. Forty years ago, my father indulged his speculative impulse by purchasing gold coins (as this chart illustrates, it was an abysmal decision). Fifteen years after that, I couldn’t attend a party without being asked to name the next superstar mutual fund manager. Ten years later, residential real estate captured the spotlight, with tens of millions of Americans hoping to turn a quick buck by flipping homes.

The wrong path

There’s no denying the reality: people will gamble with their assets, despite all the warnings to the contrary. It's best, then, that those gambles be understood as such – that they be held and regarded separately from the investor’s essential investments. Back when defined benefit plans were prevalent, stock accounts served that purpose. It was acceptable to take chances with stock accounts because, for employees who qualified for company pensions, their equity holdings were a bonus. They could live on their pensions alone.

Then things became muddled. As defined benefit plans were eliminated, replaced by company-sponsored retirement accounts, the two prongs converged. Responding to employee requests, account line-ups began to add exotica, such as emerging-markets funds, technology-stock funds, and self-directed brokerage platforms. In the 1990s, the prevailing wisdom was that participants would use their retirement accounts for two purposes. Those accounts would contain both their essential assets and their house monies.

That was a dangerous policy, as was demonstrated by several bleeding-edge retirement plans that suffered large losses during the 2000-02 tech-stock downturn. Better to disconnect the two prongs, so that investors understood they possessed two investment buckets. Their retirement plans should own only humdrum assets. If that occurs, with an acceptable contribution rate, then the outside accounts can be invested more aggressively, perhaps even speculatively.

Separate and distinct

That is largely what exists today. Although many retirement plans continue to offer brokerage platforms, they receive little use. Nor are specialised funds popular. Most 401(k) assets are invested in conventional fare. So too are a large portion of outside accounts, either with the assistance of financial advisers (who increasingly rely on highly diversified model portfolios), or through direct purchases of index funds. Those are the next generation’s essential assets.

Separate from those are the house monies, dabbling in collectibles or chasing meme stocks. If those trades fail, they fail. Many who make such purchases are also steadily socking away essential assets into their retirement plans, paycheque by paycheque; most are young enough to overcome their failures. 

In short, it's likelier that younger investors will become dissatisfied with their speculative purchases than reap outsize gains. But the damage to most will be limited. The real danger to the fortunes of retirees comes not from mistakes made outside of their essential investments, but instead from within. That is not occurring.

This article was originally published on Morningstar.com. John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

is Vice President of Research for Morningstar.

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