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Bushonomics is the continuous consolidation of money
and power into higher, tighter and righter hands
George Bush Sr, November 1992.
First of let me state that I am not a specialist in the area this page devoted too. I am more of regular lemming taken for a ride with many others :-). And that's why I wrote those note. It was written first of all for my own consumption as an exercise of increasing my understanding of the previously unknown to me field, the field that actually not that different from programming (I have found that people with very limited understanding of statistics and primitive simulation models are often treated as geniuses in this area). I made the note available on the WEB in a hope they might be useful for other programmers too. They are pretty raw as I have no time to polish them. All usual disclaimers applies.
First of all I would like to remind myself and the readers that Bushonomics, in the unforgettable words of George Bush Sr., is “the continuous consolidation of money and power into higher, tighter and righter hands”. That means that proper name for 401K investors is 401K donors. Actually the best thing that happened during last administration is that they failed to privatize social security[ http://economistsview.typepad.com/economistsview/] :
Had we done so, boomers facing retirement over the next few years would be even worse off than they are today. Now they’re struggling with pension plans worth less than they counted on, and home values that are tanking. At least they can rely on a monthly Social Security check.
But had we privatized, they’d be totally reliant on the stock market. And look what’s happened to the market: Compared to stock values ten years ago, the S&P 500 has risen a little over 1 percent a year, adjusted for inflation. Even Treasury bonds have done better. Go back nine years and there’s been no gain at all. Go back eight years and the market has been off an average of 1.4 percent a year.
Yes, I know, it’s been a rough time. First the tech bubble bursting, then 9/11, then Enron, then the housing bubble bursting, then the credit crunch. But that’s my point. We can’t necessarily rely on the stock market. ...
Sure, the stock market has done well over the past half century. But there have been decades like the 1970s and this one, so far, where it’s been a disaster. That’s why we have Social Security – so that if your timing is bad and you get caught in a downdraft, you still have something to fall back on in retirement.
But in 2008 tables turned and even without privatizing social security the things became interesting. 401K donors did not even realize that they are being pick pocketed. As WSJ recently wrote the whole 401K complex is merely a fee machine, and always was. That means that only the most lucky guys will get back what they put in ( after inflation). Everybody else will get skimmed...
Bushonomics actually explains why income from work is taxed at nearly twice the level that capital gains. Everyone needs to remember that no matter where you put their 401K money to preserve buying power you are simultaneously feeding the financial sharks who are playing reckless games. And it is you who will be paying the price due to predatory nature of this relationship (with 401K donors in the role of the prey). Your attempts to increase your nest egg by trying to find better investment strategy might backfire unless unless you are very, very careful:
Now the rich person having $60M/year in fresh investment money can invest that money very efficiently and can afford to have very competent investment advisers. They might very well make an after-inflation return of 3% off of conservative investments.Our poor but thrifty person either puts the money in the bank (getting perhaps -3% after inflation) or follows the advice on the TV networks and loses even more money buying overpriced stock and getting caught in pyramid schemes.
Another telling quote from FSO Editorial Here Come the Modern 1930s by Thomas Au (03-20-2008):
Former Fed Chairman Alan Greenspan, one of the major architects of the current crisis finally “fessed up” the other day when he referred to the current crisis as the “most wrenching since the end of the Second World War.” But the end of the Second World War marked the start of the boom times in America (at least for those who lived to tell the tale) so he must really be referring to the crisis since the beginning of the Second World War, which would be the late 1930s. And this decade is basically where we’re now at.
The modern 1930s are the logical consequence of the “New Economy” of the past decade, just as the original was a logical consequence of the “Roaring Twenties.” In each case, technology and leverage combined to create a potent but ultimately poisonous brew of wildly inflated asset prices. In essence, greedy CEOs (and investment managers) said, “we brought you the new economy, please cash us out now.”
And a gullible American public affirmed this by bidding up prices to insane levels, expecting to share, rather than subsidize, the wealth of the selling shareholders. First the tech companies, then the financial intermediaries were then caught in traps of their own making, and escaped as sorely crippled entities, if they survived at all. But by this time, the more privileged players had “taken their money and run.”
The 10-yr. adjusted for inflation annualized gain of the S&P500 turned negative quite recently for the first time since 1973-83, the worst bear market in after WWII history. Dean Baker in his Year of the fat cats made a very similar observation:
...If we go back 10 years, we find that the ... average real return on [the S&P 500] ... has been 3.2%, a bit lower than the yield that was available on inflation-indexed government bonds 10 years ago.
This is rather striking. It is unlikely that many people invested in stock for the sort of return that is typically associated with government bonds, which are much less risky. At least for the last decade, stockholders have not been rewarded for taking this risk. [ It was Wall Street that was rewarded for all the risk 401K investors had taken --NNB]
This brings us to the topic of CEO pay. We saw an explosion in CEO pay that began in the 1980s and has continued into the current decade. ...
This explosion of pay at the top was justified by many economists based on the returns that they produced for shareholders. The argument was that even these incredibly high salaries still were just a small fraction of the value that the CEOs generated, so their pay was money well spent. These exorbitant salaries gave the CEOs the necessary incentive to produce extraordinary returns.
In its current form 401K plans are a as close to scam designed to feed middlemen as one can get. The selection of funds is heavily biased toward stocks and often the mutual funds offered have fees close to criminal. 401(k) should be structured like the Canadian RRSP or the Chilean Individual Pension Plans. That is, anyone can invest a certain amount tax-free per year in any vehicle they wish. No more "Here, you got 10 mutual funds to invest in and that's it", the limitation that more then anything else suggest the nature of the relationship. Returns should controlled and underperforming funds kicked out of participation is 401K. Right there, 75% of the mutual funds industry would get a much needed kick in the pants. Performances should be reported before all fees and after each and every fee then after all fees are accounted for. A mandatory graph would show projected losses generated by said fees at 10, 15, 20 and 30 years, and included in ANY prospectus. Every trade performed during last 3 days before end of quarter should be disclosed on every mutual fund web site. ("window dressing?"). In Buttonwood Gored by the bull published by Economist in May 2007 the author states:
According to Chris Watling of Longview Economics, the top 1% of households owns around 40% of America's wealth—the highest proportion since 1929. In the 1970s, they accounted for just 20%.
This creates its own problems, especially when workers are increasingly expected to provide for their own retirement. After all, many companies are retreating from the provision of defined-benefit (final salary) pension schemes because of the cost. As companies switch to defined-contribution (money purchase) schemes, workers not only receive, on average, lower contributions from their employers; they also lose an insurance policy against poor stockmarket returns (because the companies were committed to make up any shortfall in the pension fund). Such a policy would be very expensive to buy in the open market.
Workers trying to replicate a final-salary pension have two further problems. The first is that high share and bond prices imply low yields (the two are inversely related). So they need a larger sum to generate a given retirement income.The second problem is that, when asset prices are high and yields are low, future returns are likely to be subdued. It thus takes a lot more effort to generate a given lump sum for retirement.
With government bonds and cash yielding 4-5% in Britain and America, financial advisers use a rule of 25. In other words, you need capital equal to 25 times your desired retirement income (equivalent to taking a 4% yield). So for a Briton to have a reasonable—but hardly lavish—retirement income of £20,000 ($40,000) a year, he would need £500,000. For most people, saving such a sum is unimaginable; they may not bother to try, given the scale of the task and the attraction of immediate consumption.Some of this reluctance may be based on money illusion. In 1990, when a Briton could earn double-digit returns from keeping his money in cash, his capital was being eroded by inflation. Nevertheless, the real yields on assets such as index-linked bonds, seen as the best match for a pension liability, are also very low. Britain's long-dated index-linked gilt yields just 1%; investing £500,000 would thus generate an annual income of just £5,000.
But 401K investors were slow to recognize that they were lured into "lose-lose" scheme and will con lose their shirt due to market volatility and that they can only count on dollars they put as inflation and middlemen eat all returns and more. The real shift in public sentiment happened only in 2008. On Feb 8, 2008 naked capitalism reported:
In the last month or so, I have noticed a marked increase in hostility towards the financial services industry, both in the number of cynical, critical comments on this blog and the intensity of their venom. These are a few from the last week:
The wealth creation over the past decade plus has been on the back of a system that has grown more corrupt by the year. It is a parasitic system that is rotten to the core and feeding off the real economy, empowered by the bankrupt foreign economic policy that has essentially given away our competitive advantages and gutted out industrial base. Who said American's aren't generous? ......
Global collusion and financial engineering gurus fused together packages of localized loan pools into globalized loan pools in hopes that the default rates would be insignificant and thus any impairment or dilution would be diluted to zero risk.
The result of what these gurus engineered is a global systemic financial failure resulting in denial on their part, no accountability on their part and defaults on a global scale never before seen. These gurus will return to Davos with new derivatives and be held in high regard, versus being placed into global prison cells! .....
Wall Street has become a conduit unto itself and a zero sum wealth "creator" for the financial economy at the expense of the real economy. We are heading for a complete disaster and the more you read this moronic commentary [from a Wall Street strategist] the more you realize that never has there been a better time to sell. Rotten to the core.
While the question about financial services are good or bad is mainly philosophical for 401K investor and he/she need to use the one provided for him/her no matter what, we needs to see bigger picture: getting reasonable returns without unreasonable risks in 401K portfolio is a very difficult task. So there are two main strategies: take higher risk (and the tables are turned against you) or accept low, single digit returns. I think the second strategy is the most reasonable for people with salaries below 100K per year and the lower is the salary the lower risk you can afford. Yes, that informally means that you will get essentially close to zero returns after inflation: on each dollar you contributed to 401K you get exactly one dollar back. Which in a way is only fair. But it guarantee that you will not lose too much due to either your own mistakes or unfavorable market conditions.
But what is important that with some false moves you very easily get negative returns and you need you need diligently work on acquiring all the necessary knowledge if you want to avoid this, avoid to be fleeced. Here is Buffett's letter to shareholders that explains the typical fallacy of double digit returns form stocks and "queen in Alice in Wonderland" situation with helpers (a.k.a. investment advisors):
I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.
There are no "long-term" straightforward investment answers for 401K accounts assets allocation anymore. Moreover, most of 401K investors including myself should be more properly called "401K donors" as few of us will be able to get returns above inflation. We are just feeding financial intermediaries (in a typical bond fund with return 5% and fees 0.5% the mutual fund share of profits is 10% of returns, the share equal to what landlords used to demand from serfs during middle ages -- 10% of harvest were usual at this time; but the landlord gave serfs land, while financial intermediaries take your money).
| There are no "long-term" straightforward investment answers for 401K accounts anymore. Moreover, most of 401K investors including myself should be more properly called "401K donors" as few of us are able to get returns above inflation. |
In a way we probably would be better off investing directly into Treasuries as most 401K plans contain very eclectic set of funds and in a way enforce kind of "straight jacket" on your investing options (you cannot for example invest your 401K directly in gold, or government saving bonds). Also some companies have 401K plans invested in funds with high fees (Wal Mart is one such example).
The question arise what allocation of assets between stocks and bonds is most resistant to eroding from inflation and confiscation by mutual fund industry. First of all most 401K plans have both stocks (often represented by index fund like S&P500 or value fund like Windsor II) funds and one or more bond funds (as a minimum so-called a "stable value fund" -- an ultra short bonds fund, but after intermediate bond fund like Pimco total Return and one high yield fund like Vanguard High-Yield fund are present).
My feeling is that bonds should play more prominent role in 401K portfolios and that some kind of age based sliding scale allocation between bonds and stocks might at least diminish losses as your portfolio automatically becomes more conservative with age (100-your age or target date funds are the simplest examples of this approach). To a large extent your success depends on honesty of your own effort in understanding the options you have, educating yourself in major economic concepts and trends, keeping your own records, doing your own simulations using Excel, and reaching your own conclusions. In way in a way investing is betting on long term trends; while speculation is betting on short term trends. For example the person who invest all his money in S&P 500 makes pretty bullish bet; how bullish depends on P/E ration (which is very raw as part of the E in this equation is often an accounting trick) and other investment metrics.
| To a large extent your success depends on honesty of your own effort in understanding the options you have, educating yourself in major economic concepts and trends, keeping your own records, doing your own simulations using Excel, and reaching your own conclusions. |
It is important to understand that the advocated by the author age-based split between stock and bonds (100-your age) is not a panacea. But it might be a good starting point for your own efforts for adaptation of this simple approach to your particular situation. The key advantage is that 100-your age strategy (with rebalancing after, say, 10% deviation from the prescribed share, where dev=(s-b)/100) is simplicity. It is trivial to simulate in Excel using data from Yahoo for any programmer. My simulations had shown that many other, more complex allocation strategies does not produce statistically significant higher returns without tweaking parameters to fit the data ("data mining").
But we need to remember that every investment strategy that seems to be well-grounded and working well in the past might at one time stop working (in a sense that returns are less then either 100% bond or 100% stock index fund portfolio whatever is greater). Typically that happens during the crisis when correlation between asset classes diminish or even reverse or during prolong bear markets which favor even more conservative strategy. Right now (as of 2008) we have a period of such uncertainty so please take my advice with the grain of salt.
That means that for any investment strategy, before you invest real (your hard earned) money, you need to test this investment strategy both on normal periods as well as on the period of crisis like 2000-2003 (for which data are available from Yahoo). Generally it is reasonable to assume that extensions are longer then contraction but exact share of expansion vs. contraction in simulations is a more difficult question (you can start with 80:20). For programmers there is no excuse to skip this the simulation step as it is able to show what are maximum losses you can suffer during bear markets, the losses that you need to be able to tolerate. It losses are higher then you intuitively understood toleration level the risk needs to diminished by raising bond part of the allocation or by introducing "stop loss " rules. For those of us who prefer Unix, Perl with Apache is a suitable substitute for Excel. It is not that difficult to generate tables in Perl.
There is also a distinct danger of data mining in strategies that are published in popular media (for example portfolios based on Financial alchemism. Data mining means that the allocation was tuned to perform well on particular historic data. I have found a good and pretty simple test for simulation model that discovers data mining: if you replace in your model one fond with another similar one, the model that was tuned by data mining stop working and does not produces similar return. The same is true if you replace one ten year period for another (I personally use a set of ten year periods for testing Excel models). If the return is considerably different that means that you tuned your model too much to the data on which you debugged it. There is also tendency to make model more complex than it should to increase returns. You should fight this trend as historic data does not predict the future and a simple, even very crude model has tremendous advantages over a complex one as you can understand it behavior and limitations better.
Also you need to take into account rare events like deep recessions. Among things "Things That Can't Happen but Happened Anyway" Mish recently listed:
I would add to the list the hypothesis that diversified stocks index like S&P500 outperforms bonds ("stock for the long run" or naive Siegelism hypothesis). Yes, it might be true for certain periods (for example ten year periods starting in any month in 1990 and lasting till 2000, and some months of 1991-2001, and then again, 1996-2006 and 1997-2007 periods). But if we assume cost averaging starting from zero, then Vanguard institutional stable value outperformed S&P500 for most of exact ten year periods with the start at random month in 1990-1998 timeframe (2008 is not over yet but it looks like underperformance will hold for the rest of 2008.)
The difference between stocks and bonds returns for some "stock positive" periods like Jan-Jun 1996 - Jan-Jun 2006 are within the rounding error and generally can be reversed by using different from Vanguard Institutional Stable value bond fond.
Also the latest trends due to subprime crisis make the situation with S&P500 returns in 2009 more problematic as financial stocks constitute approximately a quarter of S&P500. That means that S&P 500 might also underperform stable value fund for 1999-2009 period and may be 2000-2010. If this is true, that for all for ten 10 year periods with starting years of 1990 to 1999 and cost averaging starting from zero naive Siegelism hypothesis is demonstrably false.
Moreover difference is even larger if instead of stable value fund one is using bonds funds like Institutional PIMCO Total Return or Vanguard bond index.
It is important to understand that in case of 401K investor all the money are not available at the start of investment period and the model should include the usage of value averaging and (often erratic and irrational) human actions like reallocations from stocks to bonds when situation becomes too tough. If we account for those, then for many 401K investors the "Bush II recovery (2003-2007)" after the dot-com crush was actually not a complete recovery from losses. Traumatized by losses in 2001-2002 they sold some or most of their stock holdings during the slump, missed large part of the rally which started in 2003 and were lured into stock market closer to 2005-2007 when the same dangers (but different type of bubble) start lurking again and materialized in 2008.
For those who remember 1999 and 2000 the key investment ideas promoted by media in 2007 are again foreign markets and, especially, emerging markets with an additional spice of decoupling theory. But decoupling might not work in 2008. It did not worked in 2001-2003 recession where emerging market behaved almost exactly like tech stocks. In some areas our current situation of subprime collapse might be even more dangerous for 401K investors then dot-com bubble deflation: both commodities boom and emerging markets boom of 2003-2007 which provided some outsized returns were out of the reach for most 401K investors. As Angry Bear blog noted:
Earlier today Cactus posted on the real Dow over the past seven years. Another comparison is to look at the alternative strategy, investing in cash or 3 month T bill. If in January, 2001 you had placed your investments in 3 month T bills and reinvested the income in 3 month T bills, at the end of December, 2007 your total returns would have been almost exactly the same as if you had invested in the S&P 500 with daily dividend reinvestment.
... ... ...P.S. In looking at the current stock market and listening to strategist this chart is an important lesson to think about. You will hear from Wall Street analysts that if you do not go back into the market and miss the first leg off the bottom you are missing a great opportunity. Of course they are right. But if you miss that first bounce off the bottom and wait to go back into the market as long as you return while the market is below the cash line you are still better off than if you rode the market down and back up.
Also important is that in the fairy tale of free-market economies, the financial markets provide for the efficient allocation of capital. In the real world the financial markets among other things efficiently provide for the transfer of wealth from the working people (and that explicitly includes 401K investors) to people in positions of power (large banks brass, hedge funds owners and new financial elite in general, which is the essence of Bushonomics). And there is enough money in the financial system to hire talented people who will do their best to sustain any desirable myth in media, no matter how absurd it is. The problem is that according to iron law of oligarchy if top 20% has all the money, then their business decisions control the directions of the economy, and their political contributions control the direction of the country. Middle class can do nothing about this trend even if it hurts their well-being. They became just milk cows.
Another interesting sign of the complexity of the current situation and dangers lying ahead for 401K investors is that when financial sector became hypertrophied a side effect is the dramatic rise of the level of corruption in the system, the level which might actually undermine the economic security of the nation. "Things happened" during S&L crisis and it looks like the same thing but in much wider scale unfolds in the subprime crisis. Just look at Countywide saga.
In any case for a regular 401K investor its important critically access the situation and resist negative effects of being brainwashed by the mainstream press. Among such effects the following were recently listed:
Mutual funds let outside investors steal from their customers for a share of the loot.
Borrowers are encouraged to take on more debt, then get squeezed into bankruptcy by rising rates.
Assuming that we managed to got sizable 401K savings we will be facing the problem: how to ensure that they are not lost their value before we retire. while this is somewhat simplistic and in reality affected are intertwined I classified threats to 401K into three broad categories:
Threats
from yourself. That's probably is a self-evident truth :-(.
The key issue here is what investment strategy is consciously or subconsciously
adopted and how viable this investment strategy is.
Threats from Wall
Street. One is perma-bull propaganda and tremendous pressure to adopt
high-stock-content/all-stock portfolios that got many programmers and IT specialists
into severe problems during dot-com crash. This problem is also can be
named "acquired idiotism" problem or "immunization from rational understanding
of risks". Many people hurt themselves because the focus is only
on stocks (and stock funds) who are promoted by sleek, very intelligent and
extremely well paid "Wall Street photo models" like talented "stocks circus
entertainer" Jim Cramer
(the host of the chair-hurling, financial advice-shouting circus called Mad
Money; Cramer's show is on so often, that it seems to run like a film loop).
Another notable "stocks promoting photo model" is CNBC's
Maria Bartiromo (aka
Money Honey; see
From Disco
Queen to Business News Diva and
Maria Bartiromo Is No Fool ).
Threats
from government. Among key factor here is the threat of inflation. That
does not nessesary means internal inflation, the depreciation of dollar againt
major currencies is the sign of the same process althouth it does not influnce
the buying power directly. But there is no doubt that the dollar plunge against
other currencies in 2001-2007 will influence retirement of baby boomers in a
profound way. All-in-all the threat of inflation is definitely as important
threat to 401K portfolios as subpar performance of stock and bond markets.
Among other less important are threats to Social Security (possible insolvency,
privatization, etc) as well as danger of making investment decisions based on
biased statistics (few 401K investors are that savvy). But it is interesting
to note that despite tremendous amount of published statistics there is a notable
absence of reliable economic information and statistical fog that is difficult
to penetrate.
Growths of economy is reflected in the sum of returns of stocks and bonds. For
a long time the lion share of those returns was returned via stocks appreciation;
but that does not mean that situation cannot reverse any time: there is no inherent
reasons why stocks should be more attractive and systematically produce better
returns then bonds. Actually for the level of risk we are talking in case of
S&P500 on bond side we should compare index not with regular investment grade
bonds but with junk bonds and they return approximately the same 6.5% annualized
return as S&P500. Current GDP growth oriented measurement of economic
growth is very deceiving as it does not reflect growing treats the nation faces
due to depletion of hydrocarbons, overpopulation and infrastructure that is
addicted to cheap oil. GDP is a very crude and somewhat suspect indicator of
economic growth. The question to ask is "Does doubling of strip malls, restaurants,
banks, or number of personal cars on the road is such a good thing ?".
Where is the level after which they does not increase standard of living and
might contribute to decrease (traffic jams in case of cars is a good example).
Also some contributors to GDP like alcoholic beverages consumption, soda consumption,
tobacco products, medical insurance costs, obesity drugs costs, etc actually
represent externalities and in no way are positive to the economics or reflecting
the prosperity of the population. GDP is a very crude, self-deceiving and one
dimensional measure.
The Section 401(k) of the tax code was enacted in 1981 as a way for people to save money for retirement outside of the traditional pension retirement plan has several side effects (as in "road to hell is paved with good intentions" ):
First it launched huge growth of mutual fund industry which before that were a small portion of financial markets.
Later the American public has actually been forced into the stock market (or more correctly into stock mutual funds) with the evaporation of pension plans because most 401K plans are heavily and openly biased toward stocks.
Later 401K plan involvement in stock markets acquired some properties of Ponzi schemes, when the stocks purchases by 401K participants due to the numerical strength of baby boomers might became important factor that drives stock prices up and provide cover for speculators (401K investors put similar to Greenspan put).
Recently it became replacement for pension but without adequate matching of employee contribution by employer to provide equal returns...
Actually few programmers and other middle-class professionals are individual stock purchasers operating through brokers; most are dependent upon mutual fund managers navigating market or on index funds. In 1990th mutual funds became huge industry and saturated mass media with expectations of profits. Although they were not the primary factor, they were constructive in creating and maintaining dot-com boom. The need to slow down and prepare for contracting credit was lost in the fast-paced world of momentum trading.
Now let's discuss if 401K plan has properties of the Ponzi scheme. If this hypothesis is true than as in any Ponzi scheme only those who are able to cash out early (the first wave of boomers) will preserve those gains. The key question is "What is percentage-wise contribution of 401K investors to equities ?". If it is dominant then this really looks like a variant of classic Ponzi scheme. This question can be simplified to the question: "What is the percentage of mutual funds holding of all outstanding shares ? " as households own dominant part of mutual funds (see FRB Z.1 Release--L.214--Mutual Fund Shares--September 17, 2007). Here are some facts which suggest that mutual funds did become the major players in equity markets:
"The public has nearly $7 trillion invested in stock funds — $6.4 trillion invested in traditional stock funds and $479 billion in exchange traded stock funds. In total, mutual fund assets equal about one-third of the $19.6 trillion U.S. stock market. (Many funds invest in international stocks, so the amount of fund assets as a percentage of the U.S. market is somewhat lower than a third.)"
Total retirement assets increased threefold over the past decade, to almost $13 trillion in 1999 (table 8).27 Mutual funds have played an increasingly important role in this growth, accounting for almost one-fifth of total retirement assets in 1999. Moreover, retirement assets held within mutual funds have risen significantly relative to total mutual fund assets, accounting for 35 percent of total fund assets in 1999. Households have chosen to allocate the bulk of the retirement assets they hold in mutual funds to equities, thus bolstering the total share of mutual fund assets allocated to equity funds (table 9). In 1999, 73 percent of mutual fund IRA assets and 81 percent of mutual fund defined contribution pension plan assets were invested in equity funds.28 Retirement account assets in mutual funds are much more likely than non-retirement-account assets in mutual funds to be devoted to equity investments.
...households’ decisions to invest new cash in, or request redemptions from, equity mutual funds significantly affect equity prices. This possibility can be evaluated by looking at the relationship between domestic equity fund flows and equity prices. Net new flows into domestic equity funds as a percentage of the value of the U.S. stock market have tended to increase over the past fifteen years (chart 10).29 The monthly percent change in the Wilshire 5000 index of stock prices over the same period shows that while equity fund flows were becoming more stable, equity prices were becoming more volatile (chart 11).30 A related development is that the response of mutual fund investors to large market declines—specifically, the equity price declines in October 1987, August 1990, and August 1998—has become progressively smaller.In October 1987, when the Wilshire index fell more than 20 percent (the worst monthly performance for the stock market since World War II), domestic equity funds experienced net outflows of more than $6 billion. This outflow amounted to 0.2 percent of the total value of the stock market, or just under 3 percent of domestic equity fund assets; this was the largest monthly outflow as a percentage of fund assets to date. Indeed, domestic equity funds experienced outflows in fourteen of the sixteen months following the October crash, outflows that summed to a net total of more than $18 billion. All told, mutual fund shareholders withdrew more than 11 percent of domestic equity fund assets in the aftermath of the October 1987 episode. 31
The next large decline in stock prices occurred in August 1990, when the Wilshire index fell about 10 percent in the wake of concerns about the Gulf War in Kuwait and Iraq. In that month, mutual fund shareholders withdrew about $21⁄2billion from domestic equity funds, which amounted to less than 0.1 percent of the value of the stock market, or about 1 percent of domestic equity fund assets. Outflows from August through September 1990 were only $3 billion, or a little more than 1 percent of fund assets. Although the Wilshire index fell half as far in August 1990 as it had in October 1987, fund withdrawals during the 1990 episode were less than half those during the 1987 episode. Domestic equity funds did not experience a net monthly outflow again until August 1998, when the Wilshire index declined 15 percent in the midst of the Asian financial market crisis and Russian bond defaults. Shareholders in domestic equity funds requested net redemptions of about $61⁄2billion in that month, an amount equal to about 0.3 percent of total domestic equity fund assets. Domestic equity fund inflows resumed the following month.
...Although investors have withdrawn money from domestic equity funds during severe market declines, mutual fund managers have not necessarily had to sell stocks immediately to cover redemptions. In addition to holding stocks, equity funds also hold safe, liquid money market assets, usually referred to as ‘‘cash.’’ The proportion of a mutual fund’s total assets held in cash is known as the cash ratio. To the extent that net outflows can be met by cash on hand, they need not translate into forced sales of equities by fund managers. The asset-weighted mean cash ratio for all domestic equity funds has generally been trending down and recently stood a little above 4 per-cent (chart 12). Despite the decline, funds have had, on average, more than enough cash on hand to cover monthly redemptions throughout the past fifteen years.
In 1980, more than 60% of Americans who had retirement plans at work enjoyed traditional pensions, with the employer providing fixed monthly payments throughout the retirement. Now the numbers are reversed. Also wages and salaries are at an all-time low as a percentage of nation wealth: despite relatively strong growth, manageable inflation, high corporate profits and a bullish stock market, real wages continue to stagnate. Actually the hidden story of the last election was the middle class revolt due to almost unbearable financial squeeze that occurred last decade. Middle class professionals like computer programmers had found themselves living with far more job risk, financial risk and income volatility than a decade ago. Mutual funds industry is structured so that managers are most often compensated based on short term performance measures and this encourages them to take on high levels of risk with investor capital. That means that you should resist temptations and adhere to a strict discipline to a greater extent as any of them will possibly be amplified by the fund managers. As Andy Kern in What Makes Warren Buffett Successful - Seeking Alpha noted:
The most important less-learnable characteristic Buffett possesses, though, is very uncommon. It is emotional discipline. By this I mean the ability to resist the natural human instincts of fear, greed, pride, regret and all the other irrational biases to which people are inherently inclined to succumb. I have been trying myself to master these biases for years and, let me tell you, it is tough. Even once an investor is cognizant of these biases he may find it extremely difficult to control them. I can’t let myself buy because stocks are going up (greed) or sell because they are going down (fear). I have to base my decisions entirely on an unbiased assessment of the underlying business. [in case of S&P 500 the US economics as a whole --NNB] This is far easier said than done.
It continues to fascinate me that many 401K investors including myself are entirely willing to base their financial security on concepts that looks quite unconvincing even a cursory look at historical data and a few Excel imitations model runs. As a computer professionals we work long hours trying to acquire hard to get skills. We try to get certifications to motivate ourself to study consistently. But when it comes to the decision related to those hard eared money we display amazing stupidity and are ready to believe into almost any nonsense propagated by mainstream press. It continues to fascinate me that many computer science professionals who are better then others are equipped to do simple Excel-based simulations and test hypothesis on historical data are willing to base their financial security on "ad hoc" concepts from some guru that can be disproved with even a cursory look at historical data with Excel in hand. This list until recently included myself.
| It continues to fascinate me that many 401K investors including, until recently, myself are willing to base their financial security on "ad hoc" concepts from some guru that can be disproved with even a cursory look at historical data with Excel in hand. |
We need to understand that suddenly 401K became "the pension plan", the replacement of traditional pension plans as they disappeared into thin air. And it requires the respect and amount of leg work that is proper for pension plan. That means a lot... The big lesson to be learned from 2001-2003 is the importance of having a properly constructed investment plan and sticking to it -- not being distracted by short-term "noise":
Traditional pension plans offered better returns and more personal security than you'll ever get from your investments. In a typical 401K plan, you need sum of your own and company annual company contribution of approximately 15% of salary to provide for 3/4 of the salary -- typical top pension for "long timers" in the traditional pension plan.
When your contributions are equal to the contributions of
the company and the company pays 4.5-6.5%, you'd either wind up with a lower
retirement income or need to put additional 5-7% yourself. That
means that you should contribute at least 10% of your salary Plus
probably Roths as an insurance and "emergency fund".
Avoid "totalitarian" or close to them portfolios:
100% stock, 100% bonds or 100% cash portfolios are more risky then balanced
between those three classes of assets. This is a very simple idea but it
has profound meaning, My limited simulations suggest that how your assets
are divided between different classes (stocks vs. bonds/cash) might actually
be more important than the individual stocks and bonds funds you hold (you
can actually hold cash instead of bonds, if you have more then 20% in stocks).
I actually respect "cash investors" despite the fact that I am skeptical
about their allocation choice. But they can predict their future income
with high precision. At the same time chasing returns many 401K investors
had thrown any caution into the wind. Cash returns are so low - courtesy
of Greenspan's ultra easy monetary policies that turn the 401K investors
'returns mad'. But that does not mean that higher returns are risk free
and nobody knows what will be the size of the crash and when it will come.
The second important idea is that as 401K selections are mostly limited to stocks and bonds both stocks and bonds should constitute the sizable portions of portfolio and close to 50:50 allocation strategies like a simple 100-your_age formula of splitting stock and bond assets might be one of the best 401K investment advices money can buy. The more secure you feel that you reach your financial goals the less stocks in the portfolio you can afford
Unfortunately it looks like most programmers prefer heavily loaded (80% or more) stock portfolio. The tendency to overload 401K plans with stocks might have been one of the contributing factors and in a perverse way simultaneously a consequence of the first Greenspan bubble (tech stock bubble of 1996-2000) despite the fact that a lot of professionals (most programmers who I know) dearly paid for such an allocation. I was one of them and that actually stimulated me to research the subject.
As a quick reality check even S&P500 might not those days provide safe store of value as financial stocks now serve as a proxy of tech stocks in 2001-2003 stock crash (mortgage crises and deleveraging crisis). The reason for the strong performance of stocks over the last 10-20 years or so might replacement since the early 1980s consumer price inflation with the asset inflation.
You need to understand that another even more dangerous part
of this situation is that government offloaded inflation
risks on the shoulders of individual investor.
As Alan Greenspan noted well
before his famous monetary base expansion efforts "In the absence of the
gold standard, there is no way to protect savings from confiscation through
inflation. There is no safe store of value."
Your investment horizon is pretty limited (for most people it is approximately 20 years (40-60). If all you can afford is a couple of decades of active investing that means that "stocks for a long run" idea might not work in your situation:
Professionals, especially programmers over 55, are
the most frequent target of layoffs (chances to be laid off for people over
55 are more than two times higher than in other age brackets). Those days
to expect to survive till 62.5 as a programmer is somewhat a stretch.
The typical period after layoff and finding new job now
can last not several month but several years (as happened with some
of my friends who lost jobs in 2002 and found jobs only in 2006) and in
most case older folks are unable to get even 80% of the previous salary
on a new job. Often they are "50% off"...
Many former programmers and IT specialists are unable to
find professional job at all and are pushed into semi-qualified labor pool.
That cuts the most intensive 401K investment period to approximately 10-20 years (45-55 in worst case and 40-60 in the best). And that means that you better do not make costly mistakes during this period and after as at this point you contributed maximum amount of money that you can relay later on.
All-in-all the professionals like programmers has been lately (probably since 2000) under serious financial and social pressure, which makes the economic experience of the past ten years significantly different than the preceding decades. It also justifies more efforts to protect your 401K investment. In any case expect you payment to be lower that in case of pension unless you contribute the maximum allowed amount (currently 20%). So in a sense you can think about 401K plan as a 20% haircut on your salary. Combination of low returns and inflation creates the situation which is called The Red Queen's Race after a scene from Lewis Carroll's Through the Looking-Glass were the Red Queen and Alice constantly running but remaining in the same spot:
The Queen kept crying "Faster!" but Alice felt she could not go faster...
"Now! Now!" cried the Queen. "Faster! Faster!" And they went so fast that at last they seemed to skim through the air, hardly touching the ground with their feet, till suddenly, just as Alice was getting quite exhausted, they stopped, and she found herself sitting on the ground, breathless and giddy. The Queen propped her against a tree, and said kindly, "You may rest a little now."
Alice looked round her in great surprise. "Why, I do believe we've been under this tree all the time! Everything's just as it was!"
"Of course it is," said the Queen: "what would you have it?"
"Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else -- if you ran very fast for a long time, as we've been doing."
"A slow sort of country!" said the Queen. "Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!"
Dr. Nikolai Bezroukov
Copyright © 1996-2007 by Dr. Nikolai Bezroukov. www.softpanorama.org was created as a service to the UN Sustainable Development Networking Programme (SDNP) in the author free time. Submit comments This document is an industrial compilation designed and created exclusively for educational use and is placed under the copyright of the Open Content License(OPL). Original materials copyright belong to respective owners. Quotes are made for educational purposes only in compliance with the fair use doctrine.
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Last modified: May 01, 2008
