Apple Pie, Economic Growth & Fatal Stock Market Flaws
Stock-Markets / Stock Markets 2014 Oct 09, 2014 - 10:05 PM GMTBy: Dan_Amerman
What is it that will actually determine: 1) how our retirement investments will perform, 2) at what age we will be able to retire, and 3) what our standard of living in retirement will be?
For the usual answers, we've been taught to turn to the assumptions of conventional financial planning. But there's a problem with doing so, which is that the path that the economy and investments have actually taken over the last decade and more doesn't seem to have been anticipated in the usual assumptions.
What actually happened with the Financial Crisis of 2008 and the following Great Recession came as quite a surprise to many, as have the unusually low interest rates which are currently pushing back the planned retirement dates for many millions of people, even as these low rates reduce retirement standards of living.
In the interest of trying to avoid future surprises, perhaps we should start by asking some very common sense questions about retirement savings, that while absolutely essential – are rarely asked. Consider the following three:
1) Can the average person really become wealthier than the average person – or do things need to add up at some point?
2) Can an entire society create paper wealth at a far greater rate than the actual economic growth rate, and then simultaneously cash out this paper wealth into real goods and services?
3) If the economy is made up of corporations, individuals, and all levels of government – and the corporations and individuals, as well as state and local governments are all using investments to attempt to compound their wealth through the markets because neither the corporations, nor the individuals, nor the state and local governments can afford to pay for retirement promises and expectations without those investment sales – then who, precisely, is it that steps in and cashes their investments out? And with what?
On the rare occasions that these questions are asked, traditionally the answers might involve professional jargon, equations and an elaborate network of interlocking academic theories (which depend on simplifying assumptions and unproven hypotheses to a much greater extent than the general public realizes).
However, there is a simpler path.
As an analogy, consider a fresh, hot pie. Let’s call it an apple pie, though it could be blueberry or cherry if you prefer. Whatever the kind, that pie smells delicious, you are hungry, and you'd like a big, fat slice of it. The problem is, so do a lot of other people. How large of a piece can you get?
That depends on three things:
1) how big the pie is;
2) how many people also want a piece; and
3) whether some people are allowed larger portions than others.
Let’s liken that pie to the national economy. It's the United States economy that we'll be discussing here, but this can apply to pies of other nations as well.
Now the marvelous thing about economic pies is that in a growing economy they just keep getting bigger, year after year. And acquiring ourselves a big piece of that pie in the future is the motivation for investing of course. We all want as generous a portion of that expanding pie as we can get, and fortunately there are plenty of people willing to sell us future pieces of that pie.
Just how big is that succulent pie going to be? Various reasonable long-term rates of return for our investments are suggested depending on the source and investment type, but a nice one is 8%. Eight percent is a good number for example's sake, not just because it is nice and round, but it represents roughly what a particular type of calculation tells us is the long-term rate of return in the stock market.
So we take $1,000 today, invest it for 30 years, and with annual compounding (reinvestment of our earnings as we get them) that $1,000 sitting in a tax-deferred account soars to a total of $10,062, including our profit of $9,062. That is the amazing stuff of which financial planning is made!
The Economic Pie
Another approach is to look at the economic fundamentals of our pie. That is, buying investments essentially means that we are buying an ownership interest in the economy. When we buy shares of stock, we become owners of that corporation. Given that the economy is primarily made up of corporations, by collectively owning those shares of stock, we as investors effectively own much of the private economy.
Over the long term in the previous century (1950-2000), the United States economy grew at about 3.5% per year after removing the effects of inflation (source: Bureau of Economic Analysis). Of that about 1.2% a year can be accounted for by population growth (source: Census Bureau). Adjusted for inflation, then, we have real growth – per person – in the economy of about 2.2% a year. Now, take that same $1,000, and invest it for 30 years at a 2.2% rate, and it becomes worth… $1,921.
Uh, oh.
It seems like there might be a problem there. We buy investments expecting over 30 years to earn a 906% ($9,062) profit from our ownership interests in the economy. But after accounting for inflation and population growth, the overall per capita economic pie has only grown 92% ($921). So our expectations for growth in investment wealth are ten times larger than the growth in the real economy.
Pie Problems
I think you can see our pie problem, which is the difference between looking at the pie, and actually eating the pie. Around fifty million Baby Boomers are planning on eating generous slices of a really big investment pie at some point down the road. Not just all of the people who buy stocks and other investments directly, but also all of those who buy them through their retirement accounts, and indeed, anyone who is planning on getting a pension as part of their retirement.
So the issue is that when we add up all the different expectations for our future pieces of Investment Pie, and compare them to what in reality the total Economic Pie is likely to be – there just isn’t enough pie to go around.
Now an individual can certainly earn a particularly fat slice of the pie, so long as they follow an investment strategy that works out very well indeed. As some investors have in the past, and as others will in the future.
However, getting back to one of those fundamental questions: how can everybody earn those big slices simultaneously, as the conventional investment models indicate they will? How can one sixth of the entire population simultaneously have their real net worth increase 10 times faster (906/92) than the real per capita worth of the nation itself?
The amount of real wealth in terms of resources is growing far, far slower than people’s perceptions of their current and future wealth, as valued by their investment portfolios. And we have an enormous group of people planning on actually selling those investment portfolios to get real resources, simultaneously, year after year. How do we make it all add up?
The answer seems clear. Which is that they can earn that wealth on paper, but when it comes to real resources, it is unfortunately simply impossible for them to all to cash it out. Like a pie, an economy is made up of the sum of its slices. And when most of the people invested in that economy are all expecting their own slices to grow far faster than we know the overall pie is growing – an awful lot of people are likely to be very disappointed.
Historical Returns & Hypothetical Behavior
As long as we are asking questions, this is probably a good place to ask another: if an 8% investment return rate and 2.2% per capita economic growth rate are both based on long term history – what’s the problem? Obviously they can coexist, so why worry?
The issue is not whether stocks can earn an 8% paper yield while the economy is growing 2% on a real per-capita basis – so long as more people are putting money into the markets than are pulling it out. Because that can work just fine, as it has many years in the past.
The issue is all the people who looked at that 8% yield, and said, “Hey, we just found a magic money machine! All we have to do is assume 100% reinvestment of our investment earnings through our pensions, investment funds, IRAs and Keoghs, and all of society together can achieve financial security! And we can run models using hypothetical investor behavior to prove it historically!”.
(The particulars for the Magic Money Machine are explored in more detail here.)
If we take an equation with a high growth rate – and let it run wild with no constraints – then the math seems to prove that we all become wealthy, or at the least financially secure.
Keep going in time, and the same math necessarily also proves that our cumulative wealth will grow until it is larger than the universe itself.
Go still further out in time, and the mathematical equations will insist that each of our individual portfolios will grow until they are larger than the universe, too.
Uh oh.
See, that’s the usual problem with running exponential equations with no outside constraints, and is the reason these equations are used with great caution in fields other than finance, or subjects other than our collective life savings.
The issue with that approach – which underlies most long term investment planning today – is that the 10 to 1 figure isn’t so much based on historical earnings as it is the hypothetical compounding. All we’ve really done is demonstrate that exponential compounding is a powerful mathematical concept.
Unfortunately there are indeed constraints, and cashing out real goods and services requires a real economic pie. If we look at actual financial history, never before have we had so many people planning on eating such nice big slices of pie, and over such long retirements on top of that. In the past, life spans were generally shorter, and the ownership of securities was concentrated in a much smaller segment of the population.
We’ve made three big changes with our hypothetical investment models, which separate our current expectations from the historical yield analyses.
1) Never before have we had so many people – and such a large percentage of the population – investing in the markets .
2) Long term exponential compounding of our wealth had not previously been the objective – or the majority's behavior.
3) (And this is the most important part), never has such a large segment of society attempted to simultaneously convert such high compounded wealth expectations into real resources, for year after year, over a period of decades.
We have never before seen anything like this three way combination. Thus the ability of the markets to withstand this unprecedented test while delivering high rates of return is not based on history, but rather is unproven theory.
More Logic Flaws & Uncommon Questions
The 2nd half of this article (linked below) poses quite a few more questions while examining additional logic flaws in the agreed-upon conventional wisdom for how we should all invest.
Daniel R. Amerman, CFA
Website: http://danielamerman.com/
E-mail: mail@the-great-retirement-experiment.com
Daniel R. Amerman, Chartered Financial Analyst with MBA and BSBA degrees in finance, is a former investment banker who developed sophisticated new financial products for institutional investors (in the 1980s), and was the author of McGraw-Hill's lead reference book on mortgage derivatives in the mid-1990s. An outspoken critic of the conventional wisdom about long-term investing and retirement planning, Mr. Amerman has spent more than a decade creating a radically different set of individual investor solutions designed to prosper in an environment of economic turmoil, broken government promises, repressive government taxation and collapsing conventional retirement portfolios
© 2014 Copyright Dan Amerman - All Rights Reserved
Disclaimer: This article contains the ideas and opinions of the author. It is a conceptual exploration of financial and general economic principles. As with any financial discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal, tax or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the article, website, readings, videos, DVDs, books and related materials, either directly or indirectly, are expressly disclaimed by the author.
© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.
