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What If Stocks Never Go Up Again?

January 5, 2009 RSS Feed Print

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UPDATE: My response to those who call this question ludicrous is now posted here.

It's a scenario that would undermine every personal finance book, market expert, and business school class out there: Such a prolonged recession -- or even depression -- that the market never gives investors the 10 percent average returns of the 20th century. Or even less-optimistic 8 percent returns.

If we can no longer count on the stock market to double and triple our money through compound interest over our lifetimes, then what will we retire on? How will we stay ahead of inflation? Most people now lack pensions and depend solely on social security, tax-protected retirement account such as 401(k)s, and private savings. But if those latter two sources don't grow in the stock market, we're all going to be feeling pretty poor as we enter our retirement -- if we're even able to retire.

This doomsday scenario becomes even more drastic when one considers how our behavior might change. If we can't earn as much on our savings, then will we become even less likely to save? Personal finance books love to talk about the power of compound interest as a primary incentive to save instead of spend. Their authors often base their arguments about how many thousands you will ultimately save by cutting out that daily latte, for example, by assuming you can grow those savings at ten percent a year.

But with the stock market down some 40 percent in 2008, that assumption isn't looking so solid. You would have been better off buying all the lattes you could handle last year rather than put that money into the stock market. (Of course, you'd be even better off if you'd stored that money in a high-interest savings account instead.)

Today's Wall Street Journal reports on the efforts of money managers to develop new models for current market conditions. Possibilities include a moderate recovery, prolonged period of sluggish growth, sharp rebound, depression, and a period of inflation. In other words, the chances of a quick return to 10 percent gains are slim.

So what is the solution for those of us worried about what we'll be able to live off in our retirement? Financial experts are soon going to need to come up with a better answer than compound interest.

Any ideas?

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Analysis of these issues routinely ignores the very real possibility that the very nature of money and profit as we know it is ending. I believe we may be transitioning to a barter economy where skills, networking and community interdependence will replace a monetary marketplace.
Upskilling in basic life-sustaining tasks such as food preservation, gardening and building relationships with people who live within walking distance might be as wise an investment as spending hours trying to visualize the profit-making potential of a future without consumer cash.

Rick of WA 9:43AM February 19, 2009

Anyone can put out an infinite number of "what if" scenarios. No one can predict the future because of unpredictable random occurrences. WWII and deficit spending cured our Great Depression, not government programs. Who could predict 9/11? Just a month or so ago, oil was supposed to go to $200 a barrel. Eight years ago, we were looking at government "surpluses as far as the eye can see." During the dot com boom, people were looking at the Internet as the "next big thing." Just as the US government set policy for national phone service last century, national broadband Internet service will probably become the new dial tone. Hedge funds and retail mutual funds redemptions exacerbated the current market drop.
IOW, all this doom and gloom is completely unwarranted. Yes, we are probably in for relatively bad time for the next 5 or 10 years because people spent a lot more money than they could pay back. But no one can predict what industries or products will excel or even exist during that time. Look at the billion-dollar industry that grew up around the Ipod.

jimmy of MD 9:05AM January 06, 2009

Excellent article. Yes, the 9-10% projections that financial planners show their clients are junk. Index funds are high risk investments and highly correlated with each other. Instead investors should be shown a range of projections that makes it clear that even ten years from now they may have less money in a fund than they put in. And 2008 has shown that most diversification across equity classes (i.e. US, foreign, REIT, etc) is a largely a myth.
There are some strategies that are potentially useful. One is to add market neutral investments. These investments are created by gaining exposure to other factors in the market such as the value and size premium, momentum premium, and option volatility premium. They are somewhat complex to create and involve derivatives.
Also remember that the S&P 500 is biased towards large growth stocks, which essentially means that you're long equities but short the value and size premium. This is one reason why the S&P 500 has not performed well historically except in the 1990s. You're much better off in smaller companies. Individually they are riskier but collectively they provide higher returns, because some of those small firms grow into or are acquired by large firms. The S&P 500 is more reflective of the return that institutional investors get because they cannot move into and out of smallcap stocks easily.
The second strategy is to use hedging. If you can't handle a 35% loss in your investment portfolio within the next five years then the only responsible choices are to either withdraw your assets from the market or to hedge the risk. The price of hedging fluctuates, and you may be able to buy a long-term hedge cheaply at times when the market isn't focused on risk. At other times you could set up a zero-cost collar that limits both your upside and downside or use a spread position in which you buy one hedge and sell another. The short-term price of a hedge also gives you valuable information about the market's opinion of risk going forward.
The third strategy is to automatically rebalance. Most investors leave their assets in appreciated investments and get crushed when the inevitable happens. Simply regularly rebalancing assets across sectors in the S&P 500 provides better risk-adjusted performance than the S&P 500 alone. (Note that rebalancing helps more by reducing risk than boosting return.) Rebalancing across bonds and market neutral investments can allow you to regularly move some of your investment profits out of the market before it corrects.
--- Tristan Yates, author of Enhanced Indexing Strategies

Tristan Yates of MD 11:46PM January 05, 2009