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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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When I started out as an investment counsel this structure was still very much in placeThe promises men live by by Peter L. Bernstein The title resonates from college days, although memory of the subject matter it refers to has faded out. The title resonates today as well, but for reasons that may not be immediately apparent. The meaning will emerge from history. The history we relate here is familiar, but the focus and perspective are different from the customary approach. Our purpose, in fact, is to offer a hypothesis that might explain the history of this extraordinary [1990s] bull market. From the Beginning of Time to the 1960s For most of financial market history, bonds were owned by institutions and trusts, while stocks were owned largely by wealthy individuals. Public speculation came and went, and wealthy people also owned bonds, but the stock market was, for the most part, a domain of the wealthy. When I started out as an investment counsel in the early 1950s, this structure was still very much in place. All our clients were rich individuals; institutional accounts were scarce as hens teeth. The institutional business in the equity market would remain in the minor leagues for another decade at least. Insurance companies, endowments, and trusts were still working under oldfashioned restraints and held minimal amounts of equities. Not-so-wealthy individuals were still on the periphery, as most of them did not yet have enough to start playing in the market while those that did have some money did not yet have the courage. The first ten years or so after V-J Day were a risk-averse era, socially, politically and economically. From 1949 to 1954, the dividend yield on stocks averaged 365 basis points over the yield on Treasury bondsmore than double the spread during the decade of the 1920s. As the conviction gradually faded that the return of the Great Depression was just around the corner, the environment began to change. The shift got under way during the latter half of the 1950s and became increasingly visible in the course of the 1960s. In those years, the shell-shocked veterans of the 1930s were beginning to disappear from the scene, due either to retirement or death a development that contributed to the acceptance of a more hopeful view of the future. Money now came into the market in the expectation that maybe this was a place that could make you rich, not just a place for the already-rich to park their assets. That was quite a switch. The Pension Fund Impact At the same time, the swelling flow of pension fund money into the stock market during the course of the 1960s, and more rapidly in the 1970s, injected a fundamental change into the process of equity investing. The whole purpose of investing had always been to make money, but precisely how much money an investor should earn in the market was a matter that only a tiny minority of people had ever stopped to consider. Actuaries in Wall Street? An oxymoron! The defined benefit pension funds, however, could not function without calculating a required rate of return. They had made a set of contractual promises, promises on which they could welch only at their peril. After the near-catastrophe in the early 1970s, in fact, ERISA [the Employee Retirement Income Security Act of 1974] came into being with the aim of keeping those promises honest. Charitable foundations were the next group of institutional investors to join in this process. Like most investors, the foundations had given little thought to the matter of required returns; they aimed simply to do their best under whatever circumstances presented themselves. Most of the funds I encountered in the 1970sand we built up a significant consulting business in the areawere managing their investments via committees of Wall Street luminaries but without any full-time professional staffs. A large number of foundations at that time were exploiting a glaring loophole in the tax system. These miscreants typically held mostly donor stock, which enabled the donors to continue to control their companies while simultaneously sheltering their shares from estate taxes and the dividends from income taxes. Doing good works was a secondary objective, often ignored altogether as the flow of dividends piled up tax-free in the coffers of the foundation. By the 1970s, Congress had slammed the loophole shut. Foundations were ordered to distribute annually at least 5% of their assets or all of their income, whichever was greater. That was a murderous requirement in the inflationary 1970s until the government relented and limited the requirement to 5% of assets. Nevertheless, as most foundations believe that they have a mandate to exist into perpetuity, earning 5%-plus-inflation became an obligatory investment objective. Soon after, the educational endowments started to think like the pension funds and foundations, setting forth explicit investment objectives and establishing systematic spending rules to govern transfers of assets from the endowment to the university budget. The promises were growing. By the time the 1980s rolled around, increasing numbers of people were being promised something, and usually more than had been promised in the past, which meant new investment groups dependent upon required returns were making their appearance. Meeting those promises during the 1980s turned out to be easier than people had expected, with high coupon bonds from the inflationary days still in the portfolios and with a bull market in stocks that moved forward with impressive energy. Figuring out the least risky method to keep promises was never simple, but the calculations were not yet colored by a sense of urgency in the objective. Solutions create problems. The enemy is us. In order to fulfill all these promises, investors piled into assets with high expected returns. This process in and of itself propelled the bull market onward, quite aside from improvements in the economic environment. Welcome as rising prices of stocks and long-term bonds may have been after the dark days of the 1970s, the soaring asset values that investors were inflicting upon themselves complicated the task of meeting required return objectives for the future. The beautiful fat bond coupons were reaching maturity or disappearing due to call. The average yield on long Treasury bonds fell from an average of 10.5% during the 1980s to 8.7% during 1990-1994. The average yield on stocks sank from 4.2% to 3.0%. Now the only way to meet required returnsto keep those promiseswas to take on even greater risk. Conventional government and high-grade corporate bond exposure in institutional portfolios shriveled, while cash turned into trash. Foreign markets with brief histories became irresistible, bonds of dubious quality sold at diminishing premiums over Treasury yields, and the accumulation of a wide variety of exotic and less liquid assets was rationalized. The latter appeared to reduce portfolio risk because of low covariances, but that appearance hid substantial and costly specific risks within the group and correlation coefficients whose stability was a matter of debate. Nevertheless, if required returns were to be earned, there seemed to be no choice but to shift out toward the further limits of the efficient frontier. Welcome to the Individual Investor Into the midst of that process came the 401(k) phenomenon, at first no smaller than a mans hand against the sky but then with burgeoning momentum. The most powerful impetus came from the swelling cohort of baby boomers, now finally reaching forty years of age. Once upon a time, people told you that life begins at forty, but in the 1990s, forty is where you begin worrying about retirement. Suddenly a huge number of novice investors were being told to think about investment in terms of required returns. It was the turn of the baby boomers to start making promises, only in this case the promises were to themselves rather than someone else. Yourself is the last person you would want to disappoint. Financial planners proliferated, brokerage houses doused their prospects with seminars, and the financial press added to the cacophony of advice about how to prepare for that terrible day of judgment, now only about twenty years away and coming closer with every hour of the day and night. Fears about job security in the private sector and about Social Security in the public sector only contributed to the sense of crisis and to the magnitude of the promises that individuals were convinced they had to make to themselves. As a result, individuals joined the institutions in succumbing to the inevitability that taking on risk was the only choice. To many investment neophytes, however, taking on risk has meant investing in stocks, but the decision was so fashionable and acceptable that the expression taking on risk has had no substance, appearing to have little to do with the possibility that the assets might end up well below that promised return. People were persuaded that they could ignore volatility, because in the long run, in the long run, in the long run, in the long run, everything would come out roses. Even though the rising stock market in fact diminished the probability that these individuals would be able to keep their promises to themselves, rising prices felt so good that the negative implications of higher prices for prospective returns carried little weight. Anyway, what other choice was there? Two related points are worth mentioning as a brief digression. Both of these items provide telling evidence of the state of mind of the individual investors. First, I recently appeared on a panel with three financial planners plus Martin Leibowitz of TIAA/CREF. We addressed a relatively unsophisticated audience. After several people in the audience had used the word fun in describing their investment activities, Leibowitz felt compelled to sound off, reminding these individuals that they would be well-advised to approach this matter in cold-blooded fashion rather than as a vehicle for entertainment. Second, the public still believes that picking a few winners in a bull market, especially risky high-tech stocks, is a certificate of brilliance in investing. One thing leads to another. The Wall Street Journal for 16 November 1998 has a graph showing that block trades had shrunk from 56% of total NYSE [New York Stock Exchange] volume in 1995 to only 48% through October 1998. Most of this loss, the Journal reports, is due to day trading by individual investors whose heads are buried deep inside their computers and whose transactions costs are minimized by the use of discount brokers. Fun indeed! Not the End of History, by Any Means All of this history is familiar, but the emphasis here is on the pressure placed on the capital markets over time by the growing volume of promises by investors large and small. The process has colored investing, and risk-taking, with a sense of urgency that represents a distinct break with earlier economic history. If the hypothesis is valid, it explains more about market patterns than simplistic notions like the effect of buy-on-dips. Why is buying on dips a great idea in the 1990s when it never was before? Yes, the 1987 experience was a demonstration of how well you can do if you buy on dips, but so was 1958 or 1962 or 1970. Stepping up to the plate after a steep sell-off is scary under any circumstances. Our point is that investors are now convinced they have no choice but to keep plugging away, and it is that sheer determination rather than pure and simple courage that drives the buy-on-dips strategy. We have to face the possibility that there is indeed only one god in the stock marketthe beneficent view of the long runand that Jeremy Siegel the oft-quoted finance professor at the University of Pennsylvanias Wharton School] is its prophet. The whole business could turn out to be self-fulfilling, with so many believers convinced through thick and thin that only the stock market can make their promises come true. In such a world, where decision making is on automatic pilot, it is possible that the careful calculations of valuation and probable expected returns that firms like ours produce will provide amusing intellectual recreation but will be irrelevant for the execution of successful investment strategies. There is, somewhere, a shock massive enough to shake loose this set of beliefs. We would be naive to deny that. The shock that can turn the tide under these conditions, however, will have to be substantially larger and more sustained than any of the disturbances that have attacked the economic and financial environment over the past twenty years. This article originally appeared in Peter Bernsteins newsletter Economics & Portfolio Strategy, December 1, 1998 ( 1998 by Peter L. Bernstein, Inc.). It is reproduced here by kind permission of the author. |
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