What the decline of stocks means for you

By Felix Salmon
February 15, 2011
Tim Duy asks me whether "the public is being pushed into a retirement dead end", and "how the average investor should manage their 401k plans in this environment". I have two answers to this; one's facile and the other's quite important.

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Tim Duy asks me whether “the public is being pushed into a retirement dead end,” and “how the average investor should manage their 401k plans in this environment.” I have two answers to this; one’s facile and the other’s quite important.

The facile answer is “I’m not an investor” — don’t ask me, because the one thing I know for sure is that my investment calls have generally turned out pretty badly, I don’t have the courage of my own convictions, and insofar as I’ve managed my own personal finances in a non-disastrous manner that’s more been a matter of luck than judgment. I could try to give you investment advice, but it wouldn’t be worth very much.

The more important answer is “I’m not an investor” — and neither are you. Just because you have a 401k plan does not, ipso facto, make you an investor. This is a serious problem with defined-contribution pensions in general: they place an onerous set of responsibilities onto individuals who are wholly unqualified to discharge them in a sensible manner. Already, such plans tend to have far too many choices, many of which are expensive long-only mutual funds which seem like a pretty bad idea for just about anybody. Trying to add alternative investments in private equity or hedge funds to the mix would almost certainly be disastrous — the dumb money coming in at just the wrong time, just like it always does.

So your 401k is going to be made up of stocks, bonds, and cash, just like it always has been. Those asset classes are, it’s true, only a subset of the full range of investment opportunities available to sophisticated investors. But you’re not a sophisticated investor, so there’s no point in feeling aggrieved. It’s possible that you might be able to invest some of your 401k funds in Pimco’s Total Return Fund, which is an active and sophisticated investor, and which happily uses very sophisticated derivatives on a regular basis to get extra return and to make money in down markets. But generally speaking, people with 401k plans should stop at big-picture asset-allocation decisions: beyond that, they’re way out of their depth.

It’s possible to argue ad nauseam about the equity premium and whether it exists; I’m very sympathetic to those who say it’s smaller than you might think. But if you’re talking about retirement money you’re not going to touch for at least a couple of decades, then stocks do look a lot more sensible right now than bonds or cash, neither of which are going to do anything for you. Are they expensive? Yes: everything’s expensive. And at some point stocks will surely drop alarmingly. But at least the earnings yield on stocks is vaguely reasonable, and you can expect those earnings to rise over time as the economy grows. And you’re certainly not sophisticated enough to try to time the market and buy on dips.

The good news about 401k plans is that you put a more-or-less identical amount of money into them every month, which means you’re dollar cost averaging quite impressively. And ultimately the best way to save up lots of money for retirement is the same as it’s always been: to save up lots of money for retirement. By far the most important number here is the total sum of dollars that you’ve put into your retirement funds over time; the annualized rate of return on those dollars is secondary. So the more comfortable you want to be in retirement, the more money you should save while you’re working. Don’t expect the market to come to your rescue, and you won’t be disappointed when it doesn’t.

There’s no point in blaming the world for its unfairness. Sure, it would be nice if you and I could buy hot pre-IPO tech companies — or at least it would be nice if we were able to pick the winners. But again, Sod’s Law says that if we could do that, the returns in that space would turn negative pretty fast.

And it’s possible that we’ll have a resurgence in the stock market, if and when the US economy starts making things again. Dorian Taylor sent me a thought-provoking email this morning which said that one of the reasons we’re seeing fewer companies tap the equity capital markets is that we’re in a phase where all of the buzz and excitement is in what he characterizes as “networked information services.”

“Relatively speaking,” writes Taylor, “these companies don’t really need a huge amount of capital at any given time because they aren’t buying stuff with it; they aren’t making or building or physically shipping anything.” (Yes, I know that datacenters are expensive, but this is broadly true.) Taylor continues:

I suspect emerging industries for which production (eventually) eclipses R&D (i.e. physically consumes stuff to make things) may still do well in the stock market. Metamaterials, space tourism, alternative energy or tissue engineering perhaps. Just not information services.

If the greentech (or any other capital-intensive) revolution ever arrives, in other words, maybe the stock market will step up and become relevant again. And for the time being, those of us with 401k plans should just continue to put our money into stocks, or target-date funds, or the like. Because we literally don’t know any better.


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Not quite sure why you are writing this now. S&P 500 has returned about 80% since the start of 2009.

Posted by RZ0 | Report as abusive

I was nodding my head at this very astute paragraph:

“The more important answer is “I’m not an investor” — and neither are you. Just because you have a 401k plan does not, ipso facto, make you an investor. This is a serious problem with defined-contribution pensions in general: they place an onerous set of responsibilities onto individuals who are wholly unqualified to discharge them in a sensible manner.”

but you totally lost me with “By far the most important number here is the total sum of dollars that you’ve put into your retirement funds over time; the annualized rate of return on those dollars is secondary.”

When we’re talking about long term compounding, which I believe we are, here, annualized rate of return is everything.

Posted by KidDynamite | Report as abusive

Kid – I think I can partial agree with you and disagree at the same time. If it sounds confusing it won’t be in a moment, I am currently trying to find the article to link to but basically the author’s thesis is this: that stock returns and inflows into your 401K don’t matter the only thing that matters is the last ten years up until your retirement when you should buy a single premium immediate annuity to fund your retirement. (Cannot find it)

That’s why I can agree that compounding does matter and why I can also agree that just putting the money in does as well. But in reality if you turned 65 in 2009 with a “balanced portfolio” you got hosed [technical term]. You may be working an additional decade ( I am not evaluating whether today’s retirees should or should not be able to retire at 65 and live 18.5 years in bliss [http://www.cdc.gov/nchs/data/nvsr/nvsr5 8/nvsr58_21.pdf Table 1])

For a concrete example, imagine you have Jane and Jim both are going along for 40 years with their 1 retirement dollar compounding at 11.7%. Jane though retires in 1998 continuing the hypothetical 11.7% return from her 31st year of work until her 40th. She turns her dollar at age 25 into a nominal 83.58. Jim though in 1998 is 52 and not set to retire until 2009. With the lost decade (2000-2009) in stocks he stopped compounding at 27.64.

So now I ask back to you what matter more the compounding or the dollar amounts you put in? My interpretation of what Felix is saying is that people should just put the $ in Treasuries and accept the real returns. Poor Jim who hoped compounding would help him retire early or richly is now going to have to continue to work until his 401K can match his expected retirement expenditures.

Posted by tcolemanuf | Report as abusive

@Kid, given that the last eleven years of investing (my prime earning years, to date) have broght essentially zero return, I think we can be excused for thinking that how much we put in is a large determinant of what we will have upon retirement.

More generally, I think Felix is saying not to expect that the miracle of annualized return (if and when it happens again) isn’t going to make up for the fact that we haven’t been saving enough to begin with.

Posted by Curmudgeon | Report as abusive

What you call “networked information services” is a fancy way of saying advertising-funded websites. They are attracting a big share of venture capital, much to the detriment of start-ups that actually build things for sale. There will be a bubble in those service websites, as the unending stream of those companies will create a virtually infinite supply of advertising slots, driving down the price of web ads, and invalidating business models.

There are things to invest in besides networked information services, but those investments aren’t happening, mostly because the VC industry is populated with business school trained sheep, who lack the ability to distinguish the difference between a trend and a fad. So they look for the next twitter, which has yet to prove it can scale to a size to justify its cumulative investment.

And speaking of investment, I would also like to take exception to the idea that people who buy and sell stocks are investors, because they’re not. They are speculators, or traders, but not investors. They are not investing in a new business, they are buying somebody else’s share of an existing business, and none of that money is being used by the company to create new business. Given that there is only a little correlation between a company’s performance and its’ stock price, the stock market is a lot like gambling, only with a little less left to chance. Like gambling, there are those who know how to game the system, but most lose to the house over time. In the case of the stock market, the house is comprised of the executives of publicly traded companies, who make their compensation the top priority of the company and siphon off much of the value, and the bookies who make markets for the stocks.

As for when there will be a resurgence in the stock market, it will probably happen when more people who want to trade stocks have enough money to do that. Right now, the distribution of wealth is such that those who hold the lion’s share of deployable capital have chosen not to use it to buy stocks, which has driven the market down. Once they change their minds, or have some of that wealth distributed to those who want to buy stocks, the market will go up. Good luck predicting that.

Posted by KenG_CA | Report as abusive

The market has always done well for investors who save for the long term. However, there is no guarantee that it will always do so.

We must remember that we only reach retirement age once, and if the money is not there, there is not much satisfaction in claiming it was unlucky timing.

What investors can do is learn to sue options to hedge their holdings and place a strict limit on both profits and losses. We may not be happy to limit profits, but avoid losses is the key to having a sufficient retirement fund – when it is needed.


Posted by MarkWolfinger | Report as abusive

Actually I crafted that term deliberately to account for businesses that could conceivably be something other than ad-supported content sites (Mint immediately springs to mind), but in practice yes that’s almost certainly what they are likely to be.

Posted by doriantaylor | Report as abusive

Portfolios can be protected by adopting simple options strategies.

Limiting profits and losses is a sound, intelligent method for achieving financial goals – even when markets fail to rise.

Posted by MarkWolfinger | Report as abusive

That “datacenters are expensive” caveat to Dorian Taylor’s theory may no longer even apply when a company like Foursquare can get well on there way and still just rent a handful of virtual servers in Amazon’s EC2 cloud.

Posted by mkenney | Report as abusive

Yeah, and even if you did it the “old-fashioned” way, it’s a bit reaching to compare scaling computational capacity to say, manufacturing capacity.

Posted by doriantaylor | Report as abusive

“But in reality if you turned 65 in 2009 with a “balanced portfolio” you got hosed [technical term].”


If you turned 65 in 2009, then you probably started saving around 1970. You slogged through 15 years of flat returns, but that didn’t matter because you were diligently putting new money into your account every month. You then watched those 15 years of savings SKYROCKET in the hottest multi-faceted bull market we’ve ever seen (or are ever likely to see).

Maybe your money has been flat over the last decade (though balanced funds should still be up on their bond returns), but the individual you describe made a KILLING on his investments. Or if he didn’t, then he has nobody to blame but himself.

Posted by TFF | Report as abusive

MarkWolfinger, I’ve given a ton of thought to this question… My youngest child is just entering school, and I’m tentatively targeting retirement when he graduates from college. Call it 20 years.

At that point I hope to enjoy a long and healthy retirement. Call it 30 years. Certainly I would be foolish to plan on less.

The amortization of principal over a 30 year retirement offers minimal benefit. The risk of hitting a period of significant inflation over a time frame that long is huge. Thus annuities aren’t a useful answer.

Instead, I need to construct a portfolio where the INCOME off the portfolio meets current needs (without asset sales) and should be expected to grow with inflation. If I can do that, with a reasonable safety margin, then I’m set.

May eventually consider options as a piece of the strategy, but my main goal is to construct a portfolio in which I will never need to sell anything.

Posted by TFF | Report as abusive

The short answer to Duy’s question should be TIPS.* But since Duy of all people would know that, I wonder what he/she is actually asking.

*How many small “investors” can really expect to do better than the 2% real return over inflation offered today by the 30 years TIPS? Not many….

Posted by maynardGkeynes | Report as abusive

Kinda late to this, but my concerns involve adverse selection rather than portfolio selection. Which stocks will be traded publicly, which will be traded privately, and who makes the decision? Will there be information transmitted when a firm decides to go to the public market rather than the private market?

Posted by framed | Report as abusive

maynardGkeynes, if true that will be a pretty serious disappointment to those hoping for 5% real returns (the conventional investment advice).

That aside, I see two potential problems with TIPS. First, I see no indication that the US is interested in meeting its obligations. It can’t even muster the political will to get the ongoing deficits under $1T annually. Second, it isn’t at all clear to me that TIPS properly capture the real inflation rate.

The biggest problem, of course, is not specific to TIPS. Small investors tend to underperform partly because they constantly change strategies, typically at the worst possible instant, and partly because they are soaked for very high fees by the financial industry. Small investors who put their money in TIPS funds will pay half a percent off the top, and are just as likely as any other small investors to panic at market fluctuations.

Posted by TFF | Report as abusive

@TFF: TIPS probably don’t capture the true inflation, but if so, neither does anything else. For example, the BLS CPI deflator is probably used to estimate the 5% real return figure you mentioned. Same problem.
BTW, there are tons of no-load TIPS funds, although .5% doesn’t bother me too much.

Posted by maynardGkeynes | Report as abusive

no-load != no-expense

An expense ratio of 0.5% annually eats a quarter of the real returns, stretching the “doubling period” from 35 to 47 years. Alternatively, if held for 30 years it amounts to a 15% “tax” on the money. On top of whatever other taxes.

Agreed that there isn’t anything superior for the purpose, but that highlights the importance of keeping costs low. In this case you can easily ladder your own TIPS and avoid fees all together. No justification for fund managers charging high fees.

Posted by TFF | Report as abusive

I would hotly contest that there are too many choices or even sufficient choices in most company sponsored 401(k) plans. The industry has resisted “open brokerage window” for a _long_ time.

It would be interesting to see the ratio of public-to-private companies over time, rather than just stats on public companies. Hoover’s might have such a thing.

I would have put the peak of total U.S. incorporated firms earlier than 1997.

Part of the answer might simply be consolidation. Think “mom & pop” drugs stores, hardware stores, and S&L’s.

Of course, from a purely portfolio point of view, one may not need a lot of companies to have decent representation. If the leading company from each of an economy’s major and minor sectors was publicly traded, you could have decent exposure to all, without having all traded. Even if sub-optimal, it’s hardly lame or dead.

One could make the argument that one does NOT want to be invested broadly in “networked blah blah blah”, precisely because there are too few of them. Low/lower capital requirements mean few/fewer barriers to entry.

Okay, enough from me. Bad cup of tea this morning, obviously.

Posted by AmicusAlso | Report as abusive

“precisely because there are too few of them” s/b “…too many of them”. D’oh!

Posted by AmicusAlso | Report as abusive

@AmicusAlso: Here’s a chart of the ratio of public companies to all US firms: http://pages.stern.nyu.edu/~gyang/charts  /SGPlot94.png

The total number of firms in the US has increased every year since at least 1980. Also since 1980, the number of corporations increased every year except 1988. The IRS keeps track of this stuff:
http://www.irs.gov/taxstats/bustaxstats/ article/0,,id=152029,00.html

I have collected a bunch of time series on this topic here:
https://spreadsheets.google.com/ccc?key= 0Avrd27tf6U4KdHRMdXdMVkNWOGJFWDFsNFVvZ0R DUkE&hl=en

Posted by guanix | Report as abusive

I make my living managing money for other people and I’ll still be the first one to advocate that any college/vocationalschool educated adult can and should take a keen interest in managing their money. Anyone unwilling or uninterested in doing so deserves whatever retirement (or lack of one) they get.

Step one is truely simple… sign up for your 401k plan. If your job dosen’t provide you with a tax advantaged savings plan then step 1a is to find a new job.

After you’ve signed up for your 401k and maxed out your company match then it’s time to open your online brokerage account and put an automatic payroll deposit in place in that as well.

If you feel like you don’t make enough money to do a 401k and an IRA then again… the most imporntant financial advice anyone can give you is not to buy this stock or rebalance to that asset allocation… it’s what changes can you make in your life to earn $22/hour instead of $11.

If the average wage earner on the street can say “I’m not an investor” — and neither are you”… then let me bolt on another part…

“I’m not and investor, -neither are you, -and that’s why this country is headed straight off a cliff.”

After I’ve made my 1st billion I’m putting up billboards on the nations most congested comuter-routes saying the following:

“Wake up to the absolute truth that 3 billion people would break the law and risk their lives to take your spot as a lower middleclass wage slave.”

If you don’t want to own a little peice of the coal mine than pick your shovel up and get back to work digging.

Posted by y2kurtus | Report as abusive