Those in the millennial generation began their adult lives by witnessing one of the greatest financial crashes in history. It would be unsurprising, therefore, if millennials avoided the stock market, much as their grandparents did after the Great Depression.
Morgan Housel, writing in the Wall Street Journal, warns millennials not to overdo it on the risk aversion. He points out that young Americans are avoiding the stock market, and advises them to jump in. He makes the same point that others, such as Wharton finance professor Jeremy Siegel, have made in the past: Over time, stocks tend to rise, since stocks represent the ability of corporations to capture value. Since humans are always coming up with new ways to create value, unless corporations stop being able to capture that value, stocks are a good bet in the long run. And when you’re young is the time that you should be making that bet, since stocks are risky in the short run, and young people have enough time to be in the market for the long haul.
That’s all well and good. It’s especially good advice if the alternative is homeownership. Homeownership is an American dream, but as a financial investment it leaves much to be desired. Owning a home makes you vulnerable to local downturns — if your city experiences bad times, you’re likely to lose your job or see your wages cut at exactly the same time that your home plummets in value. So homeownership is an un-diversified investment that also limits your geographic mobility.
But there’s a third investment option for millennials that is even better than stocks — in fact, it’s better than anything else out there. It’s paying off student loans.
Millennials tend to have huge amounts of student-loan debt. The interest rates on much of this debt are surprisingly high. The rate on the cheapest kind of federal student loan, Direct Subsidized Loans for undergraduates, is now 4.66 percent. The most expensive, Direct PLUS loans, will cost you 7.21 percent. That doesn’t sound like a lot compared with a credit card, but remember that we’re in an environment where the yield on 30-year Treasury bonds is only about 3 percent.
Paying down student debt is an investment. It’s the same kind of activity as investing in stocks or bonds. If you pay down $1,000 of student debt that was costing you 7 percent interest, you just effectively achieved a 7 percent return!
How does this stack up against stocks? The historical annualized return of the Standard & Poor’s 500 Index, going back as far as we can go, is 9.07 percent (all the returns in this article are in nominal terms). That is more than 7.21 percent, and significantly better than 4.66 percent. The annualized return over the last 30 years has been even better, at 11.14 percent. But the annualized return over the last 10 years has only been 7.36 percent. And measures such as the Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), or alternatives, predict relatively modest returns from the stock market over the next few decades — perhaps only 2 percent to 5 percent.
Now realize that stock investments come with a lot of risk. The Sharpe ratio of stocks is less than 1, meaning that the typical swing in the stock market is bigger than the average excess return (rate of return minus the “safe” rate). If stocks crash, as they often do, and you need the money – to pay for an injury or other sudden expense — you'll have to sell at a big loss. And stocks don’t necessarily bounce back — Japanese stocks, for example, have been in secular decline since 1989.
In comparison, paying down student loans is almost risk- free, and offers a better risk-adjusted return than stocks will get you. Sure, interest rates could change — if rates rise by a lot, 4.66 percent or even 7.21 percent could look cheap. Also, sudden inflation could erode the value of student debt, making those who prepaid look like suckers. Finally, there is the possibility — eagerly hoped for by many millennials – that the government could forgive large amounts of student debt.
But these are fairly remote possibilities – there is no whiff of inflation, interest rates seem destined to remain low for a good long while, and student-loan forgiveness remains more hope than reality. .
So for millennials staggering under the weight of student loans, paying down those loans is likely a better bet than investing in stocks.
Noah Smith is an assistant professor of finance at Stony Brook University and a freelance writer for a number of finance and business publications.
© 2014, Bloomberg News