Frugal Living & Managing Risk, I

It goes without saying that as a frugal person, I am always looking for news ways to save money, as well as receiving a good return on my savings. The dilemma that I am faced with is one that everyone, frugal or otherwise, have to contend with: balancing return and risk on one's savings. The traditional advice that investment professionals have always given is to invest in stocks in the long run because stocks have historically given the best returns over time. The 2008 financial meltdown has challenged this popular view, leading to much soul searching and a reconsideration of risk by many professionals. It appears that many folks put their blind faith in the assumption that the stock market produces positive long term growth of their retirement and other investment portfolios, notwithstanding the oft-cited disclaimer that past performance is no guarantee of future performance.

I found myself thinking about this when I was browsing the New York Times Online on Sunday, March 29 and an article, Now the Long Run Looks Riskier, Too caught my eye. In that article, Mark Hulbert challenges the conventional thinking that the stock market produces good long term returns, aqnd Hulbert cites a recent academic paper, "Are Stocks Really Less Volatile in the Long Run?" by Lubos Pastor, a finance professor at the University of Chicago Booth School of Business and Robert F. Stambaugh, a finance professor at the Wharton School of the University of Pennsylvania, who turned to Bayesian analysis, which was first articulated by an 18th century English mathematician and Presbyterian minister, Thomas Bayes to consider how the uncertainty of future outcomes affect risk. The Bayesian approach is opposite of traditional statistical methods that analyze historical data, which, as the two authors pointed out may not occur in the future. Hulbert summarizes:

Applying Bayesian techniques, the professors found that reversion to the mean isn’t powerful enough to overcome the growing uncertainty caused by other factors as the holding period grows. Specifically, they estimated that the volatility of stock market returns at the 30-year horizon is nearly one and a half times the volatility at the one-year horizon.
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In an interview, Professor Pastor emphasized that the last two centuries could easily have been less hospitable to the United States, most likely lowering the stock market’s returns. An investor couldn’t have known in advance that the United States would win two world wars, for example, or emerge victorious from the cold war. In any case, he said, there is no guarantee that the next two centuries will be as kind to the domestic equity market as the last two.

If Pastor and Stambaugh are correct, then Americans have to rethink what they understand by risk, especially long term risk and reconsider how they plan their short and long term savings. Frugal living is not simply a question of saving every cent, but also thinking of the returns on one's frugal efforts.

In the next part, I will share my own experiences on this topic.