Economic and political analysis-Window on culture-Media criticism

Saturday, June 02, 2012

Investing for the post-Boomer era

I'm not much into making predictions. Trends, though, do interest me. A trend can tell us about our future. All too often, predictions are wrong. Trends, though, are proven right in more ways than one.

Demographics, for instance, change the economy. Follow the demographic trend, and you'll see a pattern. In the 1950s, babies were born. Companies with offerings like Pampers prospered. Later, it was Milton Bradley and their board games; hula hoops for teenagers. Later on, as the Boomers aged, they needed cars and starter homes.

Throughout the Boomer generation lifecycle, companies have sought to capitalize on the number of potential purchasers of their products, their market. This number is quantifiable--the number of people of a certain age shapes the size of the market for any particular good or service.

The downside to a demographic up trend is of course a demographic down trend. Just as the size of a market grows, so too does it inevitably shrink.

Capitalism has come up with a number of ways to analyze changes in economic variables over time. Perhaps the most compelling is the Kondratieff cycle. The idea is that capitalism has a long drawn out growth cycle, which ends in corrective episodes every 70 years or so. Take the Depression (1930s) and add seventy…well, you get the idea.

Rather than fixate on the length of time between cycles, it's far more valuable to understand capitalism is not a linear economic progression but rather a economic process that needs to reset itself in order to grow to the next plateau, where hereto unimagined possibilities can be realized.

Many on the Right speak of creative destruction, the pain and suffering that needs to come as part of the economic growth process.  Typically, creative destruction is seen as a short-term sacrifice necessary to purge the existing order of inefficiencies related to the allocation of capital.

The allocation of capital is just a fancy way of saying where the money goes. In our age, we tend to assume anyone can invest anywhere, like through a stock market. Well, we didn't get to the point where we could have the range of investment choices we now do without having gone through a transition from a less efficient capital market to the one we have now. Before we could select from mutual funds, we could only pick individual stocks, or savings bonds.

The capital markets now offer investment choices that were unheard of a generation ago. It was only through the liberalization of financial products--innovation--that we got to where we are today. Without changes in product offerings, we'd never have had the democratization of stock market investments.

Look at the 401(k) for instance. It's a product that allows any employee offered a 401(k) by their employer to invest in the stock market. It's a regulated product. Whatever matching the company offers to one employee, it must offer to another. If the CEO puts in 3% of his pay, the company's 401(k) contribution will be matched for him just like it will be for the janitor.

410(k)s are regulated under ERISA (Employee Retirement Income Security Act.) This is an essential element of fairness. If for instance, the CEO were the only one participating, the plan could be stilted to serve the interests of top management, and exclude equitable provisions for lower level employees. ERISA requires plans to be periodically tested so that this doesn't occur.

Another risk if plans aren't regulated is of course the misappropriation of funds. Federal laws governing contributions force companies to place the money in the hands of plan director who can be sued by plan participants.

401(k)s do require individual participation. Unlike pensions, which vest over time and depend on the employer's investing acumen and fiscal solvency, 401(k) funds are kept elsewhere. The company has a fiduciary responsibility to make sure the plan participant's investments go to the fund and stay there; the plan administrator may or may not be the company itself. Typically this function is outsourced, due in no small part to the liabilities involved with mistakes for which the employer is legally accountable (the plans aren't liable for market losses.)

One of the huge threats to retiree financial security todays are pensions (defined benefit plans.) The federal entity responsible for insuring pensions, the Federal Pension Guarantee Corporation, is woefully underfunded. With so many retirees, companies have to allocate huge sums to meet their pension obligations--or not. Unlike 401(k)s, pensions aren't guaranteed. (In both types of plans, you have the risk of market loss, but with pensions, there's the problem that the money the company promises to put in--the vested portion--won't be there.)

Without proper stewardship, 401(k)s investments can be misallocated. We saw this in the past with Enron and takeover targets. If company employees are allowed to own company stock, then they face a risk of losing not only their jobs should something happen to the company but their retirements as well.

The Ayn Rand crowd praises individual responsibility for retirement, and appreciates 401(k)s more because they're not an entitlement like pensions, which every employee of a particular age is entitled to get, based typically on their years of service.

401(k)s serve as a wonderful device to broaden market participation. More people invest when they're allowed to do so through tax-deductible contributions. Taken out before taxes, a much larger amount is available to go to work in the markets. Like an IRA, the 401(k) investments are freed of taxes on income and capital gains thrown off over the lengthy span of time known as our working years. Four or five decade of tax-free compounding provides people with return far greater than would be the case had they kept the money outside the IRA tax shell, or bucket, as I often describe it.

Market participation is a wonderful thing for the markets because individual investors are better for the stock market than speculators. Yes, you heard me right, despite all the hype about day traders, the better path is to get average and ordinary people investing. You won't hear that in any of the financial service company marketing: they're geared towards more frequent transactions because they make more from trades than they do from investments, which are typically buy and hold.

Individual investors are more likely to weather the storms that regularly batter the financial market. 401(k) investments in particular offer a far better alternative to speculative trades because the frequency of trading is limited by plan rules. Also, with the exception of company stock, many 401(k)s limit what they offer to mutual funds. Funds aren't are not immune from market risk--spreading investments out among a number of stocks or bonds--but they do reduce risk associated iwht holding a single stock or issue.

Another wonderful benefit of market democratization and individual investors is the positive feedback loop generated when the markets rise. Who hasn't heard a co-worker brag about how much they "made" from their investments. As with any feedback loop, there's a negative side as well. If the markets tank, broader participation might exacerbate market pessimism, and discourage participation or risk-taking--which does need to be done in order to earn superior returns. Fortunately, people are far less likely to admit market losses…Joe at the office water cooler won't be talking about his bad days like he will his good ones.

With demographics, what makes a trend beneficial can become a big liability if the trend dies. The Hula Hoop industry, for instance, didn't do so well with the aging of the Baby Boomers. What happened instead was that as the opportunity for one industry shriveled, another grew. As the Baby Boomer kids left their Pampers and Monopoly behind, they went on to Schwinn bicycles and cars.

We're clearly in a transition now, brought on by an end to the Boomer's peak earning years. The next question, and scary one, is how much pain we'll have to go through before the old investment paradigm finds a new and better balance.

Trends in retail investing

According to CNBC's Maria Bartiromo, retail investing is dead. The banks aren't making any money selling to individual investors. And if they aren't making money on selling something, they of course won't try as hard, although Maria did question the wisdom of spending a lot to make a little, which is quite significant for any potential investors in Morgan Stanley or JP Morgan stock.

That's the problem with CNBC these days: they're far more concerned with investor class (the 1%) than they are with retail investors. Back in the soaring market days of the 90's, retail investing was quite the rage. In the media, fund managers like Peter Lynch (Fidelity Magellan) were deified almost daily. His style of picking stocks based on companies that he used as a consumer led to huge returns.

Looking back on it, a gorilla throwing darts to randomly pick stocks could have done exceptionally well during the Baby Boomer ascent period. Still,t he media did have a big role in educating investors, a crucial first step in inducing them to invest, and navigate the ups and downs with some degree of confidence.

Market performance begs the question--do higher returns in themselves inspire higher returns? If market performance lags, then people will be less likely to invest and market malaise follows, which then discourages new money from entering the system and diminishes expectations and appeal, etc.. 

The market crashes of 2001 and 2008-9 provided plenty of reasons for individual investors to avoid the markets. There's a general impression that market volatility has increased; perhaps it hasn't but the size of big prices movements that comes with a higher Dow does contribute to that potential misperception. At Dow 1000, a move of 2.5% or so--like Friday's-- is only 25 points. "Dow down 25 points" sounds a heck of a lot better tab "Dow down 250 points."

Whatever, the investor psychology, the demographic trends means that fewer people have rising incomes as the Boomers age. Incomes typically peak at age 46 or so. Fewer people holding decent-paying jobs also means less money available for investing. The statistics are scary: under half of all Boomer's have saved more than $10,000 for retirement; the average net worth of Americans in their age bracket is something like $1,000.

Basically, the increasing costs of living mean people will be forced to pull out their retirement savings to keep up with costs. Health care is a huge drain of retirement savings--it wouldn't be a stretch therefore to say that health care costs are therefore a drain on the stock market?

I saw a survey from Fidelity that said retirees will have to spend $240,000 of their retirement savings on health care expenses, inferring that Medicare really won't be there for you when you retire, or at least not cover the true, full costs of medical care. Rising out-of-pocket costs for health care are a huge threat to people's solvency and, by proxy, their ability to keep their retirement savings in the capital markets.

As the Boomers' withdraw from retirement accounts, the net effect on the stock market is negative--financial industry professional truly concerned with the long term effect of rising health care costs should help fight them by pushing for universal care and the containment of costs.

As appealing as it might be to market financial services to the top 10%, market democratization builds a more stable market which attracts more investment. Sure, incomes aren't what they once were, and the costs of living are going up. But the amalgamation of individual investor into pooled investment accounts like the 401(k) can provide a recurring source of working capital going forward. And the benefits of democratizing the returns can act as a feeder for further gains and investments into the economy, with all their concordant benefits, not only in the financial markets but the Real Economy as well.

Economically, the Boomers' were the most successful generation in American history. A tragedy it would be if the result of so much societal advancement is an inter-generational relapse away from more efficient and prosperous capital markets.

The best way that the financial industry can move forward is to embrace the individual investor.  Media companies like CNBC can do a great deal to de-glamorize the day trader and market speculators, who simply can't provide an appropriate role model for our young people, who need to be encouraged to invest for the long haul. 

The media need to emphasize how stock market investing has advanced our standard of living not just for wealthy Americans but for the average citizen as well. The best benefit of putting money into the economy is that it creates jobs and economic growth; the financial implications evolve from that primary function rather than substituting for growth in the Real Economy.

Deferred gratification is perhaps the best lesson that long-term investing offers. All too often in young people and their media-saturated environment today, marketers stir wants into needs, and offer immediate gratification as the solution. In order for the next generation to mature and accept responsibility, that chain needs to be broken.

Older Americans have an obligation to offer the young opportunity that they had. If the Boomers are content to just sit back and draw down their retirement accounts, they shouldn't be surprised if they find their portfolios fading faster than they anticipated. Younger Americans need to have economic opportunities available to them and the best way to do that is to feed income and saving back into the economy through the capital markets, instead of using them to speculate, or pay for wars, or health care, offshoring, or whatever.

Looking at the recent bubbles, one in tech and the other in housing, we know the investment landscape is vulnerable to short-term thinking and profit-taking. Nothing great ever came easy. Until young Americans are taught to defer gratification, and capital markets democratized, our country will be headed in the wrong direction, and the economic/financial transition to the post-Boomer era will be especially and unnecessarily painful.


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