An interesting approach that I have never thought about is the CAPM (capital asset pricing model) with a lifetime of investing. Typical financial advisors will tell you to load up on risk when you are young and then ease off of it as you get older. One might think this makes sense but it is a mirage. The concept that when you are young you expect to have more time and could make up a loss if one was taken. The question is why you would take that risk if no additional return is granted. According to the CAPM which is widely accepted, diversification of risky assets reduces unsystematic risk (the risk which an individual stock contains that can be diversified away. In contrast is systematic risk which is also called market risk and cannot be diversified away). So why should an investor stock up on risky assets such as stocks at a young age and bear more risk than is preferred? It would make more sense to develop a well balanced portfolio of stocks and bonds and hold a portfolio that matches ones risk preferences. An individual’s risk preferences might change over one's life but betting that markets will be positive long enough for you to recoup your losses is irrational. Investors, especially average people should not take bets that they do not understand. A market can crash at anytime and as Maynard Keynes once said, "Markets can remain irrational longer than you can remain solvent." Don't be fooled by high end investment banks.
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| Fischer Black |
The inspiration for this article is based on the thoughts of Fischer Black. For those of you who don't know who Fischer is, he is the father of financial engineering and one of the brightest minds the world will see. He was many generations ahead of his time in the thoughts he produced. He is still very controversial due to his forward thinking. He is also the only person I know that believes as I do in a general equilibrium. I hope that this article makes you think twice about your investing practices.
