Diversification for Lemmings

Email Print
FacebookTwitterShare

I
have reached the age where I am begrudgingly beginning to admit
that I am no longer a kid anymore. This forlorn realization, which
good friends and good drink are unable to long quell, brings with
it the fearful realization that I need to think about the time I
will not be able to work, that blissful utopia that all WASP males
and others refer to as retirement.

The
mathematical education that I obtained while I was earning degrees
in engineering, coupled with the fact that most of my mail comes
from Bill, i.e., phone Bill, gas Bill, etc., have enabled me to
realize that to retire I must have more than my wits, I must have
money. So in an effort to ensure a diet of something other than
Alpo in my golden years, I have set out to educate myself in investments
that will enable me to eat real people food when that day comes.

The
popular wisdom is to invest in the stock market, and the common
mantras are "invest for the long term" and "diversify,
diversify." It is as if they all went to some 3-day cookie
cutter investment school where they all learned the same canned
answers that always apply regardless of the investor and regardless
of the market. Even given the fact that the market has been diving
like a peregrine falcon after a pigeon, they still insist the best
plan is to put your money in the stock market.

Now
even though I have done only a little rocket science in my life,
I can still recognize that holding my money in savings at 2% interest
is better than putting it in a mutual fund that is currently operating
at –20% interest!! If the market ever looks like it will improve,
I can always put the money in savings into it then. For some reason,
this fact seems to escape many financial advisors. I fear part of
it is the fact that these advisors have always been pounded with
the statement that "historically, the stock market returns
12%."

Having
a masters degree in engineering pretty much qualifies me as a math
nerd, so I therefore decided to pull the historical data on the
S&P 500 and see about this great rate of return. What I discovered
was less than comforting. Much less?

The
chart below is of the S&P 500 values on a month-to-month basis
from 1871 to the present. It is presented in a logarithmic chart
as are most charts depicting stock prices. Now the wonderful thing
about a logarithmic chart is that the effective interest rate is
the equivalent to the slope of the graph. The slope of the line
is simply how much the value increases for a given time. If you
recall high school algebra the slope of a line is the rise over
the run, in this case, the rise is the value, the run is the time.
The steeper the slope the greater the interest rate.

Armed
with the simple fact we can deduce some truths from the graph. Truth
#1 the slope, and therefore the effective rate of return changes
with time. Truth #2 each positive slope (bull market) is followed
by a negative slope (bear market). Truth #3 each bear market (with
few exceptions) is significantly steeper than the bull market that
preceded it. Truth #4 sometimes the amount of time it takes for
the market to significantly advance is decades. These truths coupled
with the fact that a worker only has a window of 20 to 40 years,
should dispel the idea that the stock market is going to net him
12% or even 10% annually on average. It may, but there is no guarantee.

Actually
running some of the numbers to calculate effective interest rate
intensifies the light that we can shine on the subject. Given the
fact that mutual funds are a relatively recent invention it would
have been impossible for the little guy to have actually invested
broadly in the market at its inception and through most of its history.
That fact aside, we can glean some knowledge of market trends if
we consider the possibility of having invested in each of the stocks
making up the S&P. If we had done so, the average value of the
stocks in our portfolio would be represented by the S&P.

In
1871 the value of the S&P was $4.40, if we start with that number
and imagine that we invested at that time we can see what our average
interest rate would be if we sell the stock at various times through
history. If we withdrew it 30 years later it would be worth $6.01,
a whopping 1% annual rate (not great for planning a retirement).
If we were to hold it until right before the crash of 1929 it would
be worth $30.3 giving us a rate of return over 58 years of 3.4%.
If we were to have held it until after the crash the worth would
only be $4.77 yielding a 0.01% interest.

Many
are probably now saying to themselves "that’s ancient history,
things are different now." That’s true. Things are different
now, yet some things are still the same. The market still follows
supply and demand, the market is still ultimately based on the economy,
etc. Indeed some things have changed, unfortunately, some of the
things that have changed may well end up making the scenario worse
than better. Going back to our imaginary 1871 investment, if we
were to have held it until the peak of the bull market in 2000 the
stock would be worth $1485 with a return of 4.6%. Still not that
great if you want to beat inflation. Better get used to fighting
Fido for dinner.

Once
again I am plumbing history to get these numbers, so lets step into
the post-crash era and see what we can learn. If we invest at the
bottom of the crash in 1932 we can pick up stock at $4.77. At the
peak in 2000 our stock would be $1485, yielding an average annual
return of 8.8%. Looking backwards from the peak in 2000 we can say
that the average rate of return on the S&P was 8.8% for the
preceding 64 years and only 4.6% for the preceding 129 years. Notice
that anyone investing in the top of the bear market post 1929 has
many years before there is ANY increase. This fact should be very
troublesome to anyone considering broad based mutual funds in the
current bear market.

Lets
give the market the benefit of the doubt in regards to his entire
history and focus our attention on very recent history. As I am
looking at retirement in 30 years, that’s a good time frame for
me to look at. If I look at the peak of the S&P and go back
30 years to 1970, I find stocks at $75.59, holding these stocks
until 2000 would have given me an average return of 10.4% annually,
something I could definitely live with, if I thought that trend
would continue. Visually examining the graph in these later days
shows that the early 70’s were pretty stagnant until 1974, at which
time they increased impressively until the crash of ’87, they recovered
quickly then started a rocket ride in the mid 90’s.

Anybody
with a concern for their future would be asking the question "why
the increase in the last part of the century?" I did, and I
am afraid at least part of the answer offers about as much comfort
as homeland security. My friend Gary North recently
advised me to read the book Rich
dads Prophecy by Robert Kiyosaki.
In the book, he reveals
that in 1974 congress passed ERISA. This act ultimately led to the
demise of defined benefit retirement plans and many people entering
the stock market through their 401(k)s. The law allowed workers
to invest tax deferred money into the market and enabled employers
to do away with defined benefit plans and to replace them with defined
contribution plans.
This led to lots more money flowing into the stock market.

Several
changes to the act during the late seventies and early 80’s led
to even more investing in the market through 401(k) plans. This
fact helps explain the rapid growth of the market throughout the
80’s. When the 90’s arrived the baby busters entered the work force,
the baby boomers started worrying more about retirement, and both
groups notice the recent successes of the market. As a result of
that, and other things, the market skyrocketed in the later half
of the 90’s. The slope of the curve during this period is extremely
similar to the slope during the 20’s immediately preceding the crash
of ’29.

Notice,
I have not even mentioned the effect of the inflated money supply;
that subject has already been hammered elsewhere. One effect we
may notice in the constant dropping of interest rates is the fact
that the downward slope of the crash is not as steep as it was after
the crash of 1929. If the market truly is simply correcting itself,
then these steps are only making the bear market last longer.

Another
point brought up in Kyosaki’s book is that in 2016 the baby boomers
will begin to retire. At this point money will begin to flow out
of the stock market. Just as those individuals inflated the stock
market in during the latter part of this century by putting money
into it, they will deflate the market when they begin taking the
money out of it. Once they reach a certain age they are REQUIRED
BY LAW to begin taking minimum disbursements out of their accounts.
This is so that the government can finally tax them for the money
they were unable to tax after ERISA was passed.

Conclusion

The
stock market is not the cure-all for retirement that many in this
country would believe. As I begin to look at it, getting into the
stock market seems analogous to going into the bush after dangerous
game; you better have done your homework, and you better have the
right equipment. If you don’t you run a high chance of getting eaten.
If you have a financial advisor that advises you to "hold"
to "think long term" and to "diversify," find
another one. Show him this graph and point out the last time we
had a bull market, bear market combination like this, it took decades
to get it back.

This
is another great example of Federal policy and unintended consequences.
Because of the high tax rates we have experienced, and because one
of the few places the average worker can have money that will not
be taxed is 401(k)s, we have an inflated market. And because of
this when these people are forced to take their money out beginning
in 2016, we will have a deflated market. If this holds true we may
see the greatest crash to date.

March
3, 2003

John
Hamilton [send him mail]
is an assistant professor of engineering.


     

Email Print
FacebookTwitterShare