The trouble with the stock market

I once worked with a law professor, a business law guy, who insisted that it made no sense for me not to put all of my retirement savings into equities rather than fixed income assets. The historical return on equities had been consistently higher than fixed income, he argued, so why wouldn’t you maximize that return by keeping all your money in stocks, at least if you weren’t looking to retire in the next couple of years?

The problem with this line of thinking is that, when it comes to investment, “history” is a tricky thing.

Suppose you had invested a large sum in an index fund tracking the Japanese stock market in December of 1989, and re-invested all dividends over time. How much money, adjusted for inflation, would you have today, nearly 30 years later?

The answer is slightly more than half of your initial investment.

And you don’t have to go discovering Japan to experience the dubious thrill of genuine long-term negative returns on equities. For instance US stock indexes declined, on average, by about 10% in real terms between the mid-1960s and the early 1980s.

Indeed if finance theory agrees on anything, it’s that there’s absolutely no reason why over the next three decades US equity markets couldn’t track what their Japanese counterparts have done over the previous thirty years.

If anything even vaguely resembling that happens, it’s going to be a social disaster of epic proportions. The reason is that, over the course of what has been a 35-year bull market in US stocks, lots of core American institutions have started behaving as if bull markets last forever.

Most notably, our entire retirement system has shifted from defined benefit to defined contribution plans.

But even the small minority of workers who still have traditional pension — aka defined benefit — plans are increasingly at the mercy of the stock market. That’s because the big public pension plans are increasingly reliant on investment returns rather than tax dollars to cover their obligations.

For example, CalPERS, the enormous California public pension system, had $179.5 billion of its $295 billion in assets invested in public and private equity as of the end of fiscal 2016.

Such systems simply can’t meet their future obligations, as the systems are currently funded, unless they continue to get robust investment returns on their assets. So even traditional pensions are increasingly at the mercy of the whims of the financial markets.

Even a decade-long flat stock market (something that has happened several times in US financial history) would be a huge problem for adequately funding the retirement system in this country, such as it is.

The moral, as always, is that we need to cut entitlement programs to help balance the budget.