The Backward Art of Investing Money
A take on current finance debates.
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
The Journal of Portfolio Management 2004.30.5:30-33. Downloaded from www.iijournals.com:80 by 125.79.152.93 on 12/23/15.
Paul A. Samuelson
PAUL A. SAMUELSON is In-
stitute Professor Emeritus at
the Massachusetts Institute of
Technology.
30 THE BACKWARD ART OF INVESTING MONEY
M
y title is lifted, I believe, from an essay by Wesley
Mitchell entitled, The Backward Art of Spending
Money. Beginning this way will I hope make clear
that being a high priest of highfalutin finance the-
ory does not imply that I think rationality in investing behavior
is either universal or even widespread.
A sizable fraction of the nations resources are committed
to mutual fund, pension fund, and brokerage organizations.
Old and new historical records suggest that their clients could
be better served by plain vanilla Vanguards or TIAA-CREFs, and
that this would release perhaps 90% of the finance industrys
resources to produce other comforts and necessities of life.
Would the efficiency and growth of our mixed economic
market be reduced by such a switch to lean and canny diversi-
fication? Or would the economys efficiency and growth be ele-
vated by such a change?
There is no preponderant evidence in favor of the affir-
mative or the negative on this. In particular, it is probably a
romantic myth that departing systematically from a broadest
diversification will generate random subsidies to venturesome
projects that average out to be socially superproductive. In
these days when we hear so much about Schumpeters creative
capitalistic destruction, we should not ignore malignant cap-
italistic destruction. The adage, It is better to have loved and
lost than never to have loved at all, is neither a tautology nor
a tested empirical truth.
When The Journal of Portfolio Management reaches new
birthdays, I become motivated by the editors invitation to
record my take on various current finance debates. Here I
address some of the more interesting questions.
FINANCE DEBATES
How should the length of the investment horizon affect
risk tolerance? This is a complicated question, much misun-
derstood. Ill discuss it last.
30TH ANNIVERSARY ISSUE 2004
 Some mathematicians and engineers used to advocate
that we seek portfolio combinations that maximize the port-
folios long-run growth rate. Should one really invest so as
to maximize the geometric mean of total returns, as that
desideratum mandates? The answer is simple: Only those
Laplacians with singular Bernoulli utility, utility of wealth =
log(wealth), should seek to maximize geometric mean. It is
a stupid desideratum to seek the greatest probability of win-
ning the biggest random lottery.
Markowitz-Sharpe-Tobin quadratic programming in
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
terms of portfolio means and variance is a powerful approx-
The Journal of Portfolio Management 2004.30.5:30-33. Downloaded from www.iijournals.com:80 by 125.79.152.93 on 12/23/15.
imation that has captured real-world converts in the way that
smallpox used to infect once-isolated aborigines. Is that
truly optimal for investors with widely different Laplacian
risk tolerances? Should Laplacians with widely divergent
risk tolerances really want the same singular proportionate
mixture of risky stocks A and B when combining them with
a safe security C? If you understand that the true answer is
no, do you understand that a rational investor provided with
only knowledge of means and covariances should not waste
that limited knowledge on standard quadratic programming?
This standard mean-variance quadratic programming is guar-
anteed to work well only for lowest-risk bettings.
Contemplate a universe with 0% Thaler-Tversky-
Kahneman irrational behaviorists, and contemplate uni-
verses with 80% of them, or with a universal 100%. Is it not
possibly the case that both the 80% and 0% alternatives
could sustain much the same Fama-Samuelson micro-effi-
cient market pricing?
For myself, I believe the evidence is strong that mod-
ern Wall Streets are approximately micro-efficient; that is, there
are no easy pickings left on the table. Like Robert Shiller and
unlike Fischer Black, however, I find this micro-efficiency con-
sistent with macro-inefficiencyin the sense that the over-
all asset indexes can and do undergo long-term overvaluation
and undervaluation oscillations about some smoother trend.
Yes, Virginia, some few traders do beat the so-called ran-
dom walk market over the long run. But they are hard to iden-
tify, and you cannot buy their services cheapfor the reason
that others richer than you and more alert than you have
already bid up the rents on their talents to the point where
they are no longer wonderful bargains. Both in a stationary
stochastic scenario and a non-stationary stochastic scenario,
many would-be Babe Ruths will for a time enjoy stellar bat-
ting averages. Fidelitys Magellan or Vanguards Windsor funds
illustrate my point: Mixing either with the S&P index in every
decade does little to augment your risk-corrected return.
Most traders who do well in any year are momentum
traders. Unlike the numerous traders with so-so perfor-
mance, the successful stars do not give back to the chang-
ing market all or most of their previous winnings. They do
this by a flair for risk avoidance that seemingly cannot be pro-
grammed into their systems formulas. All the veteran stars
32 THE BACKWARD ART OF INVESTING MONEY
have a healthy concern about risk, but seemingly they can-
not codify their concern.
I illustrate by a little story. Z garnered profits in futures
market trading 49 out of 49 years. He became patron saint
to a new trading group. They apprenticed to him for a whole
year Y, a young trader, who wrote up a privately printed book
summarizing Zs various wisdoms. Alas, Y as a trader was him-
self never able to break even in any subsequent year. (An Ivy
League physicist analyzed the acoustics of fine violins. From
his laboratory measures he concluded: The only difference
between a Stradivarius and an expensive 1990s manufacture
is somewhere in the overtones. Thanks a lot.)
Mathematicians know that stock price changes have
short-run serial correlation coefficients that are positive,
while longer-run serial correlations are negative. (Blue noise
evolves into red noise.) Alas, knowing this doesnt seem to
enable one to garner lush trading returns. The Good Book
says, There is a time to remember and a time to forget.
Alas, we need a better book to inform us on how and when
we should shift our gears.
Self-serving bar associations benefit from the dictum:
He who is his own lawyer has a fool for a client. God must
have loved the lone-wolf investor because he made so many
of them. More likely it was the Devil, because an accurate
tally of how they do as a group over their lifetimes would
tell a sorry story. Just as alcoholics bamboozle themselves at
the same time that they bamboozle their handlers, lone-wolf
investors talk in the locker rooms about their winners, not
their losers. Only their spouses and the IRS are aware of their
true net losses in what is a negative-sum game.
Most investments are sold, not bought. Reading Forbes
and Barrons, the surgeon general warns, can be injurious to
your long-term financial health. There is nothing so dan-
gerous as a good new story. Exciting investing just beggars
you faster than the dull kind. Thats why Darwinian evo-
lution has made paranoid wives less vulnerable than high-
T husbands (T = Testosterone).
Can the heirs to high or moderate wealth buy the
brains they did not inherit? We do not have solid and
unbiased samples of performance records at the big private
banks, big investment brokers, and the big brokerage fran-
chises. That fact by itself is circumstantial evidence that
mediocrity reigns there as elsewhere.
Since the early-2000 bursting of the high-tech bubble,
the ribbon clerks at Vanguard, CREF, and such have incurred
the same percentage losses as the broad equity indexes. How
could that not be the case, when their mantra is to end up
with a beta of exactly 1.000?
This has bred the quixotic notion that the time is ripe
to drop off the wagon and revert to self-decision-making.
Reinforcing this non-sequitur is that the 2002-2003 upswing
in Wall Street has been strongest in the dogs that suffered most
in 2000-2001.
30TH ANNIVERSARY ISSUE 2004
 Is this case for self-choice cogent? Not really. About
half of undiversified portfolios will by definition have bet-
ter and worse movements around the diversified average.
Schumpeter used to say that the top dollar rooms in capi-
talisms grand hotel are always occupied, but not by the
same occupants. Next time instead of oil magnates it will be
mall developers or software nerds or investment bankers.
Look under the Ivy Leagues building ivy, and the names you
read on the friezes will document Schumpeters story.
To truncate what could be a long list, following every
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
quasi-crash, people realize how much better they could
The Journal of Portfolio Management 2004.30.5:30-33. Downloaded from www.iijournals.com:80 by 125.79.152.93 on 12/23/15.
have done if only they had timed their investmentsthat is,
timed them in accordance with hindsight. Will Rogers put
it well: Buy stocks before they go up, and sell them after they
stop going up.
Studies of a thousand actual timers tell a dismal story. Its
easier to sell when P/Es have soared, but it is hard to get back
in before the new balloon goes up fast. And it is a mathemat-
ical error to think that a husband who is half the time long and
half the time short is only duplicating across time his wife who
is always half-and-half in risky stocks and safe bonds. If
both lack skills to be the first in the mob trying to anticipate
cyclical and stock price turning points, and to act ahead of full-
time macro experts, it is the husband who suffers the most
because he adds to his bad judgments about GDPs his losses
from having abandoned optimal security diversification.
As promised, I conclude with some of the complica-
tions involved in the length of time horizon debates. In a truly
random white noise market, the law of large numbers that
reduces the variance of random errors about an unchang-
ing mean by
 N, does not apply. Repeat, does not apply.
If my more risk-averse wife maximizes the harmonic
mean of cumulative portfolio return, while optimistic I
maximize ( la Bernoulli) the geometric mean, each of us
as young and old rentiers should freeze our equity ratios at
our particular preferred different levels. We differ at age 30.
And differ the same way at age 60. The investment crowd
finds this hard to understand and believe.
It is another matter if most families have risk tolerance
that increases with wealth. If 50/50 in stocks and bonds is right
for us when our wealth is $500,000 and 75/25 is right at
wealth of $5 million, then at 35 we ought to realize that the
nest egg in hand is most likely to grow a lot in the next 30
years. Planning for retirement, even at 35 we should set our
risk tolerance the way we would if we already had much of
the wealth were likely to have at 55. Ponder the points.
Its not because actual riskiness erodes over the
long horizon that the young with good future
wage prospects should raise their equity ratio.
Its because of those good prospects, taken into
some account now.
30TH ANNIVERSARY ISSUE 2004
Those who know the literature understand other
complications: A young professional cannot make
liquid the present discounted value of her human
capital. That factor can by itself justify that she be
more risk-tolerant in the handling of her non-
human capital.
Also, as pointed out by Bodie, Merton, and
Samuelson [1992], if a professional can count on
working harder to offset any extra losses coming
from heavier equity fractions, that can be a valid
reason for raising 50%-50% to, say, 75%-25% now.
If in life we will not face the white noise of truly random
walk but instead will face the red noise of mean-reversal, then
those of us who are more risk-averse than Bernoulli (more
cautious than the geometric mean maximizer) should thereby
rationally raise 50%-50% to, say, 75%-25%. (Paradoxically, for
those more risk-tolerant than Bernoulli, presence of future
mean-reversal red noise will mandate that they drop from
50%-50% to 25%-75%!) Gollier [2001] is the best book on
the nuances of this old familiar debate.
SUMMING UP
Post-Bush ideology will in all likelihood permit future
workers to withdraw part of their Social Security credits into
private self-managed accounts. Why? Because that will work
out well for the greatest number? No. It is virtually guaran-
teed to work out expensively for most people. But the
finance industries will make out well, doing their usual
mediocre job for their clients who have Social Security
funds to invest. Lobbyists will grease the skids to favor a sys-
tem with gratuitous deadweight losses and inefficiencies.
Thats how plutocratic democracy works itself out.
Optimists think that people get the democracy they deserve.
Pessimists like me fear the optimists are right.
REFERENCES
Bodie, Zvi, R.C. Merton, and W.F. Samuelson. Labor Supply
Flexibility and Portfolio Choice in a Life-Cycle Model. Journal
of Economic Dynamics and Control, Vol. 15 (1992).
Gollier, Christian. The Economics of Risk and Time. Cambridge: The
MIT Press, 2001.
To order reprints of this article, please contact Ajani Malik at
amalik@iijournals.com or 212-224-3205
THE JOURNAL OF PORTFOLIO MANAGEMENT 33