How to Save Social Security!
Here is the idea. Instead of privatizing Social Security, we could have the US Government start up its own Mutual Fund using part of the Social Security Trust Fund. The Mutual Fund would take advantage of its economies of scale and target a 6% control of the predicted Total Market Valuation of the NYSE. It would circumvent its potential for corruption by basing its investments on a conservative investing strategy implicit in a simple algorithm that would only require 27 weeks of publicly available NYSE data. Almost everything would be based on simple but reliable statistics that could be verified by others. The goal would be to save Social Security, improve on the return to people's savings therein, and to stabilize the NYSE and attract more long term investment in it.
An example of the reliable statistics used is the total predicted NYSE market valuation. It would be based on the sum of the predicted total market valuations for all of its stocks that have been in the stock market for at least 27 weeks. The predicted valuation for each stock would be based on the median trends of their valuations from the previous 27 weeks. These predicted values would then be used as weights in the investment decisions and a simple panel-data regression that would be used to decide the weekly holdings of the mutual fund.
The secret to the algorithm, what would make it a conservative investing strategy, would be that all the stocks in the stock market would be valued on the basis of their weekly log-returns, the log of 1 plus the percentage weekly return in value for a stock. 26 weeks of data would be used in a simple mean regression to predict the next week's log-return for each stock. The weekly log-return would have several advantages over the weekly return for the evaluation of stocks. It would fit with what has been shown to be human nature in Prospect Theory. People tend to be more averse towards losses in wealth than gains in wealth. The log-return would weight losses more than gains and mute the importance of larger gains while increasing the importance of large losses in value. To illustrate this:a 20% loss would have a log-return of -.097, a 10% loss would have a log-return of -.046, a 10% increase would have a log-return of .041, a 20% increase would have a log return of .079. This measure of value would reward stable stocks and penalize unstable stocks.
The fund would then each week invest two-thirds of its funds, based on the target of maintaining a 6% control of the predicted total stock market valuation, in buying long in the top 20% of the stocks (weighted by their predicted total market valuations) and the remaining one-third would be used to sell short(making money for the fund off of a decline in stock value) in the bottom 5% of the stocks. This would reflect a chastened optimism that would hedge well against a worst case scenario of a general decline in the stock market value. The higher concentration in the selling short would be to compensate for their higher volatility. The specific holdings of each company in both groups of stocks(the ones the mutual fund would buy long on or sell short on) for each week would be based on a standardized value of their predicted weekly log-return.
This sort of strategy could easily be tested using historical stock market data, including the 1987 stock market crash, or even the Great Depression. Although the Mutual fund would likely perform better due to its considerable market power. I am convinced that if it targeted 6% control of the NYSE that it would save Social Security and provide more stability for the US Stock Market. It would maybe force out some of the more volatile stocks, discourage stockbrokers from trying to time the market, and reward long-term investment strategies like that of Warren Buffet and Berkshire Hathaway. I also think that the overall reduced volatility of the market would then attract more capital away from hedges like bonds so that it can be allocated more productively.
If this issue were paired with requiring companies to list compensation under employee option plans as a direct business expense, it would make a decent rallying point this fall for economically progressive candidates, perhaps especially in Conneticut.
dlw
Well, the transformation from return to log-return doesn't change the value that much.
I think it still makes sense to use the log-return to assess stocks, but am uncertain just how much of a difference it would make by itself in terms of how stocks were ranked and the stability of those rankings.
An earlier version of this idea involved using predicted median returns rather than mean returns, along with the predicted standard deviations. I think something along those lines, perhaps substituting log-returns for returns might be ideal. In the previous idea, there would be 3 options for people, one option would pick stocks based on an index of value that would weight the predicted standard deviation twice as much as the predicted median return, the second option would weight the predicted median return by twice as much, and the third would be some combination of the two.
At any rate, the economies of scale of the US Mutual Fund and its level of diversification and the low overhead would have a serious impact on the stability of the returns to the mutual fund by itself, regardless of the way the funds were ranked and picked.
I think the median log-return with one lag would do a more reasonable job of prediction than the mean log-return or return with one lag. But that could easily verified using historical stock market data.
dlw
A blog-activist dedicated to the reduction of the faith-based political acrimony in the United States of America so as to make our political system more democratic and just and to improve our witness to the rest of the world.
July 5, 2006 11:49 PM | Reply | Permalink
The goal would be to save Social Security, improve on the return to people's savings therein, and to stabilize the NYSE and attract more long term investment in it.
At least until the Bush administration, social security didn't need saving. Is the NYSE unstable, or at least, more unstable than usual? When did that happen?
It would maybe force out some of the more volatile stocks, discourage stockbrokers from trying to time the market, and reward long-term investment strategies like that of Warren Buffet and Berkshire Hathaway.
Market timing is inherent to markets. Is the market not rewarding long-term WB-BH strategies anymore? When did that happen?
Seriously, if the US even had a remote hand in doing what you suggest, confidence from the rest of the world would go to zero.
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July 6, 2006 1:05 AM | Reply | Permalink
SeaShell:Is the NYSE unstable, or at least, more unstable than usual? When did that happen?
dlw: It can be more stable and it has shown itself to be prone to speculative bubbles. The US Mutual Fund would seek to be a stabilizing influence that would also save Social Security.
Market timing is inherent to markets. Is the market not rewarding long-term WB-BH strategies anymore? When did that happen?
People trying to time the stock market may be inevitable, but it is not productive and can be discouraged with long-term investment encouraged.
Seriously, if the US even had a remote hand in doing what you suggest, confidence from the rest of the world would go to zero.
Whatever. Why would that be the case? What is your reasoning?
As you'll note in the post below, I think the log-earnings measure would work better if coupled with using a median regression to make predictions of the weekly median log-earnings and its median standard deviation. A median regression minimizes the absolute value, rather than the square, of the differences between observed and predicted values. It would be more stable and using its predictions to determine the holdings of the US Mutual Fund(s) would ensure greater stability in the NYSE.
It would chase away some more volatile stocks, but it would compensate by reducing the volatility of the NYSE overall, which would naturally tend to attract more capital away from being held in hedges like bonds.
dlw
A blog-activist dedicated to the reduction of the faith-based political acrimony in the United States of America so as to make our political system more democratic and just and to improve our witness to the rest of the world.
July 6, 2006 1:30 AM | Reply | Permalink