Fear Not the Bubble, Academic Says | Chief Investment Officer

Bubbles are extremely rare and attempts to avoid them entail substantial downside for investors, according to research.

Yale School of Management’s William Goetzmann argued in a paper that both investors and the media focus too much on “a few salient crashes in financial history.”

“Bubbles are booms that went bad,” he continued. “Not all booms are bad.”

From a study of 21 markets from 1990 through 2014, Goetzmann found only 10% of market booms resulted in a bubble. Market prices were more likely to double again than crash after a 100% gain.

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“Bubbles are booms that went bad. Not all booms are bad.”According to the paper, there was only a 4.2% chance of market values halving following a 100% price boom. The probability of values again doubling exceeded 8%.

A longer boom period somewhat increased the probability of a crash, Goetzmann wrote. After three and five-year run-ups, market values fell by half 4.6% and 10.4% of the time, respectively.

“It is important to recognize that the overwhelming proportion of booms that doubled market values in a single calendar year were not followed by a crash that gave back these gains,” Goetzmann wrote. “Most models and analysis of stock market bubbles focus on a few well-known instances.”

Studying these extreme examples outside of broader historical context could be misleading and costly for investors, the finance professor warned. Instead, investors should also get to know the bubbles that did not burst.

“Placing a large weight on avoiding a bubble, or misunderstanding the frequency of a crash following a boom is dangerous for the long-term investor because it forgoes the equity risk premium,” he wrote.

Regulators can also learn from the non-bubbles, Goetzmann wrote, in deciding whether deflating a hot market would truly guard against a financial crisis.

Goetzmann Bubble Source: William Goetzmann’s “Bubble Investing: Learning from History”

When it comes to defined contribution (DC) plan design, less is more.

A smaller menu of pension fund options can lead to greater total savings for retirees, according to research by Wharton School benefits specialists Donald Keim and Olivia Mitchell.

Their study focused on a large US nonprofit’s plan streamlining effort. The result? A smaller slate of options produced aggregate savings of $20.2 million over a 20-year period, or $9,400 per participant.

“Too many choices may create confusion, resulting in poorly-informed consumer decisions,” Keim and Mitchell argued.

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A large menu of funds led to participants selecting “inadequately diversified” portfolios, and also discouraged participation altogether.

“A more succinct, reduced lineup not only makes things simpler but it actually improves decision-making.”

In the Wharton case study, the nonprofit began with a slate of almost 90 mutual funds, including equity, target date, and bond index funds, as well as real estate investment trusts (REIT), commodities, and other sector funds. During the overhaul, the employer eliminated 39 of these options from its DC menu.

The new plan design had four tiers: Tier one, the default option, consisted of 13 low-cost target date funds (TDFs); tier two included four index-linked funds, and tier three comprised 32 stock and bond funds of varying risk categories, plus a private equity REIT. The final tier was a self-directed brokerage account, which participants could opt into to regain access to the closed funds, as well as thousands of other mutual funds.

Following the simplification, plan participants significantly reduced their allocations to stock, sector, and international funds and shifted their contributions mainly to TDFs—resulting in portfolios that were “better balanced and less risky,” Keim and Mitchell wrote.

Additionally, the streamlining led to reductions in portfolio turnover, expense ratios, and the number of funds held by participants, contributing to greater total savings.

One of the country’s largest DC plans has gone much further than the studied nonprofit.

The University of California’s investment office has narrowed its DC lineup from 100 options down to just 16, including TDFs, according to associate CIO and COO Arthur Guimaraes.

“A more succinct, reduced lineup not only makes things simpler but it actually improves decision-making,” Guimaraes told CIO. “That’s been important.”

But he also cautioned that a simple fund menu isn’t a cure-all for securing the well-being of plan participants.

“The problem with DC is that members run the risk of running out of money,” Guimaraes said. “If you can crack that nut and guarantee people income… I think that’s the real next frontier.”