Will Demographics Explain Financial Market Returns?

March 8, 2012

One of the arguments for modest equity returns in the coming decades is based on demographics.  This was recently discussed in an article by Karen Damato, WSJ:

If you’re a baby boomer, you’ve got a big problem when it comes to the investment returns you can expect in retirement: It’s the sheer number of other boomers who are also getting ready to leave the workplace and rely on their portfolios to help pay the bills.

This has always seemed like an oversimplified analysis to me, especially when you consider that the lion’s share of financial wealth in the United States is held by the very wealthy.  James Groth, Real Clear Markets, provides the data:

Eighty-three percent of all financial wealth in America is held by the top 10 percent, and nearly half is held by the top 1 percent according to NYU economist Edward Wolff’s analysis of the Fed survey cited by Governor Raskin.

To what degree are the wealthiest Americans going to be “relying on their portfolios to help pay the bills?”  I don’t know the answer to that question, but it’s quite possible that the wealthiest Americans will be able to pay their bills from the income provided by those investments and other sources rather than being forced to draw down their portfolios.  Furthermore, global investors may step up to bolster demand for U.S. financial assets.

As usual, there is no crystal ball.  I suspect that the global financial markets, and quite possibly our domestic markets, will provide plenty of opportunities for strong gains in the coming decades. However, investors will need to save diligently so that they have the capital to participate and then adopt flexible investment strategies that can adapt as needed.

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From the Archives: Constancy of Human Behavior

March 8, 2012

NY Magazine recently interviewed James Grant, well-known financial philosopher, to get his take on the economy and financial markets.  The article is full of nuggets of wisdom, including the following:

Grant’s second cause for optimism is an observation about human nature, summed up by an epigram he borrowed from the late British economist Arthur C. Pigou: “The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.” As peculiar as our economic circumstances may seem to us right now, the way people behave has a certain reassuring constancy—which is to say, we freak out and then we get over it.

Human behavior, if left unchecked, makes it virtually impossible to generate superior investment results over time.  The wide swings in optimism and pessimism that are part of the human condition present a serious challenge to the flexibility required to capitalize on investment opportunities.  Rather than trying to train ourselves to be emotionless (which won’t happen), our solution is to rely on systematic relative strength models (which are emotionless.)

The reality is that there are times when we should be pessimistic and times when we should be optimistic, but without a system to overcome behavioral tendencies, we are likely to be unable to capitalize on those opportunities.

—-this article was originally published 12/29/2009.  We are about three years from the market bottom in March 2009 now and it’s very clear that the error of pessimism was born a giant!  Investors have continued to pile into bonds that are now trading at 50x their coupon rate, while a 100% gain in the broad market indexes has gone unnoticed.  That Pigou was a pretty smart guy.

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More on Inflation

March 8, 2012

Recently, I ran across information on the Everyday Price Index (EPI), which measures inflation only for items that people buy every month.  A new car would not count because you don’t buy one every month.  Gasoline and toothpaste would count, since those are items that you purchase on a continuous basis.  The inflationary impact of price changes in weighted by the importance of the spending category. So, for example:

…even large increases in prices of goods that account for only a small portion of everyday spending will not move the EPI by much. One significant example is prescription drugs. Prices of prescription drugs rose faster than the overall EPI, more than tripling since 1987. But during this period, the share of prescription drugs in everyday spending fluctuated between a mere 3.3 and 1.9 percent.

The second-largest increase, of more than three-and-a-half times, occurred in the prices of motor fuel and transportation. This category accounts for a much larger share of everyday expenditures—between 14 and 20 percent over the years. Fluctuations in fuel prices not only translated into significant fluctuations in the overall EPI, they contributed to its rapid rise.

In 2011, the Bureau of Labor Statistics reported that CPI rose 3.1%.  However, the EPI, the stuff you buy each and every month, rose 8.0%.  You are not imagining it—there really is significant inflation in everyday items.

You might not be able to do anything about inflation, but you can make sure that your investment policy is flexible enough to incorporate asset classes that might help you cope with it.  Hmm…some kind of Global Macro strategy, perhaps?

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Fund Flows

March 8, 2012

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs).  Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders.  Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

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