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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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The returns on money markets and bonds cannot support the lifestyle to which this group is accustomedPROGRESS REPORT: HOW THE NEW DOMINANT INVESTMENT SYSTEM IS ALREADY EVOLVING As we completed the manuscript for this book in July 2002, the consensus was, in fact, that the financial markets have run aground probably for keeps. Nearly everyone has the intuitive sense that something has come to an end. As is often the case, the school of public opinion is very insightful. Something has come to an end an outdated perception of investing and the old investment culture that supported it. But the stars are perfectly aligned to bring in a new investment culture more germane to our way of life and, consequently, with more wealth-creating power. Although the transition process is giving us some uncomfortable moments, the sooner the old system dies out, the better. In the meanwhile, the new investment culture is proceeding apace. Historically Significant Participation in the Financial Markets In 1998, when the new dominant investment system was born, people 44 years old and younger owned a record amount of stock. These individuals belong predominantly to the reactive generation. Source: infoplease.com. The tendency has been to attribute the extraordinary high percentage of stocks owned by those under 44 to the so-called market bubble and dot-com frenzy in the last years of the decade. This explanation for the increased interest in stock by young adults is too simplistic. Now that we understand the personality of the reactive generation, it is clear that their propensity for risk taking and personal financial gain has a great deal, if not everything, to do with their enthusiastic participation in the stock market. The operative fact is that this trait will not go away. In the same way that we have come to accept the stereotypical (yet true) clich that the huge population of baby boomers investing for retirement will keep the stock market healthy, we will adopt a new truism: that the risk-taking reactive generation, driven to accumulate personal wealth, will also continue actively to purchase stock. And what stocks will they buy? The reactive generation in 2003 is between the ages of 21 and 41 and has absolutely no allegiance to the companies of the old dominant investment system. They could care less that Coke, DuPont, or Exxon-Mobil enabled granddad to leave a decently sized family estate. They do know that they use and help to create tools, products, and services that their grandparents had never conceived of and (if still alive) clearly do not understand. The reactive generation will invest in the Digital Dow2 companies that they work for and that their friends and family work for. Even those employed by secondary investment system companies will become familiar with the products and services of Digital Dow2 corporations as more Dow-style companies will be adopting the new tools and methodologies in order to survive. Baby boomers will not suddenly stop investing for retirement either. With interest rates at the lowest levels in decades, the returns on money markets and bonds cannot support the lifestyle to which this group is accustomed. The growth potential for quality stocks is far more appealing, especially at the historic beginning of a new investment cycle. The media are filled with data explaining that the baby boomers (and the older reactives) will be the beneficiaries of the biggest transfer of wealth in history as their parents either move to retirement homes or pass on. Most of this wealth is in highly appreciated real estate. Several trends are converging that are likely to result in the sale of this property and the reallocation of proceeds to the financial markets. In the book The Roaring 2000s Harry Dent posits that the typical baby-boomer family will be moving into the trade-up home-buying cycle from ages 34 to 43.19 This means that the cycle will peak between 2000 and 2004. Additionally, many older boomers have purchased sec ond homes in areas that are remote from their places of employment. Wireless and digital connections to their jobs allow these second-home owners to spend more time in what were formerly vacation homes. In short, the independently thinking boomers and older reactives have not waited around to inherit mom and dads house, and it may not be their cup of tea anyway. Another factor that will give beneficiaries second thoughts about keeping the old homestead are property taxes. Municipalities short of funds have raised taxes consistently over the last five years. Because they are already paying high taxes on their principle residence and possibly a second home, an additional tax bill could be out of the question. This will be especially true for trophy homes. In booming towns and cities the affluent trophy home has appreciated handsomely, and its property taxes have skyrocketed as well. Living in Sarasota, Florida, it is common to see property taxes on residential homes at $25,000 to $40,000 per year. Taxes on waterfront homes can range from $80,000 to well over $100,000 per year. The 5% or so of the wealthiest boomers will keep these homes. The rest will not. Harry Dent expects that, as occurred in the early 1990s, these homes will decline in value fastest when the population boom peaks in 2009.20 Estate taxes will be a major factor in the liquidation of valuable real estate. If mom and dad are worth $5 million and $2 million or $3 million is in real estate, property may have to be liquidated to cover the federal estate tax bill. The nine-month deadline that must be met restricts sellers and may impact the final price. Finally, inheritors of property will tend to sell it because it does not generate cash flow. Maintenance and repair is costly. Management and administrative issues connected with renting the property to create cash flow will not be an option for most boomers who are already occupied with careers and family. One or two of these issues by themselves would be enough to create a wave of property sales. Taken together, it is easy to imagine billions of dollars of liquidity created from the sale of real estate and the proceeds being invested in the stock market, possibly helping to drive the acceleration phase. A Better System of Analyzing Mutual Funds Is Evolving It should be clear by now that solving the problem of investment selection through an evaluation of what is past history at least by the time one does their analysis is a futile exercise. We have produced studies and given examples of why systems intended to rank mutual funds on past performance are not merely ineffectual but often will result in the investor s selecting the fund that in the future will be the absolute worst. Proof of this was in the study Lipper Analytical Services performed on the mutual fund research company Morningstar. This study was cited in Chapter 7. One reason selecting a top-performing fund of the last three to five years almost guarantees that it will become the worst performer is the fact that the style sectors of the market (large cap, small cap, etc.) cycle in and out of favor. This too has been explained in great length. In an affirmation of the kinds of fundamental changes we can expect to see during the formulation phase, Morningstar announced that it would change its rating system effective July 30, 2002. Morningstar now recognizes the cyclical nature of performance by comparing funds against those with similar emphasis. Small-cap funds will be ranked only against other small-cap funds. Morningstar should be commended for taking such an important step. Although they will continue to use the one to five star system, it will begin to reflect the realities of the new investment culture. Divorcing the S&P 500 Is Finally on the Table; Separation Is Imminent A lot of things can change in six years a point we have been trying to make throughout. Six years ago, after developing our thesis and starting to put it on paper, it was hard to believe, even for us, that icons like the Dow and the S&P 500 would become irrelevant. Proof that major changes can occur quickly, and are in fact underway, is in an article that appeared on May 14, 2002, in Institutional Investor Magazine: The S&P 500 is not the best benchmark available. Back in the early 1960s it was but not anymore. (William F. Sharpe, Nobel prize winner in economics) The S&P 500 is a goner. (Harry Markowitz, Nobel prize winner in economics) I championed S&P 500 indexing and believe I was right in doing so. But you might find that indexing to the S&P going forward underperforms as a result of the artificial pop in the stocks that comprise the index. (Jeremy Siegel, professor at the Wharton School of Finance) 21 William F. Sharpe developed the capital asset pricing model, a cornerstone of modern portfolio theory. He is one of the most respected financial theorists in our industry. Harry Markowitz pioneered the theories of optimization and risk management used by every modern laboratory of finance today. Jeremy Siegel has been on the forefront of academics seeking objectively to quantify modern market behavior. The article further states that since 1999, one-third of the 300 major pension plans monitored by Chicago consulting firm CRA RogersCasey have stopped using the S&P 500 as a benchmark. The S&P 500 will not go away anytime soon. S&P collects $80 million a year in licensing fees from the index. Billions more are collected from mutual fund companies who sell clones of the index. These are steely filaments helping to hold up the web of the old dominant investment system. Investors must avoid being caught up in it. What is needed is for academia to produce an index along the lines of the Digital Dow2. It should represent the new dominant investment system with companies from every sector of the economy. Somehow, licensing it for commercial use should be made off-limits, and mutual fund companies and insurance companies should be prohibited from cloning it. Because companies would not enjoy an increase in the value of their stock by having it in the index (if the index is sold commercially, a companys inclusion in it means more investor dollars will automatically go toward purchasing the stock), there is a better chance for objectivity in the determination of which stocks ultimately comprise the new index. |
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