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This month, the first part of a two-part essay. This article is intended for the educated layman. It was written as part of a continuing series of articles on a variety of investment topics. To view all the articles in this series, click on “More by the same author” in the left margin.
Part I: Why We Do It and to What Extent
Isn’t it a little late to be asking this, after ten essays about investing? Shouldn’t we have begun with this question? No, it wasn’t an oversight: We weren’t in a position to answer before we gained our bearings. We had first to orient ourselves among the fundamental concepts of investments and thereby locate the path forward.
Investing has its rational justifications, but like any human activity, it’s contingent upon history. American society has come to regard investing in stocks and bonds as a matter of personal responsibility and even an obligation. Authorities and economic experts, not just editorial writers, stockbrokers, and shills for mutual funds, tell us that we should invest in order to raise the funds needed to pay for our retirement, for health insurance, and for our children’s college education. Though corporate managers and politicians may abuse our trust, we are nonetheless democrats in a polity of property owners, and the property we own includes stocks and bonds. As Mitt Romney so simplistically rendered this idea on the campaign trail in Iowa, “Corporations are people.” But it was not always thus.
How it all began
When life expectancy at birth was only about 65 or less – within the lifetimes of some who are still living – there was little expectation of any retirement. Pensions existed, but so did old-age penury. On average, personal wealth was much less, but so were many big expenses, like college education, and not just because ordinary household price inflation has made them seem more costly today. Workers, if they had any surplus remaining after paying expenses, saved it in the bank or some other institution that promised to safeguard it. Stocks and bonds, even government bonds, were regarded with suspicion, and not without justification, in light of the way company promoters and the brokers of stocks and bonds practiced upon the public. Financial securities weren’t esteemed as assets, like real estate. That’s not to say that middle class folk didn’t invest in stocks at all. I’ve seen a late nineteenth-century Wall Street brochure that was hawking stocks for a brokerage, and except for its typography, it wouldn’t have looked archaic a century later. But it took an ideological revolution in the early twentieth century to turn a democracy of yeomen holding real, physical assets into a democracy of workers and the middle class holding both real assets and financial assets. This was largely the accidental outcome of a dialectic between those who demanded regulation of the stock market for the protection of the public, and the New York Stock Exchange and its corporate friends, which defended the market as a public service.
In 1890, no New York Stock Exchange member firm ran even a single branch office for the convenience of retail clients. It is estimated that even as late as 1917, no more than 2.5% of American households owned any kind of financial security, stock or bond, corporate or government. Though, as Calvin Coolidge said in 1925, “the business of America is business,” at the turn of the twentieth century, corporate share ownership was more broadly diffused in Britain and France than here. But World War I caused roughly a third of the American population to buy a federal government bond, and then stock ownership followed. By 2001, 53% of American households held the stock of a corporation either directly or indirectly (through a mutual fund or a pension plan), though this fell to 45% by 2008.2 Presumably, the proportion holding bonds as well as stocks was even higher.
As common investors began to trust in financial securities, they identified the return on bonds with coupon income, and the return on stocks with dividend income alone, which unlike price appreciation, seemed to be certain and real. In an earlier essay, we’ve reviewed why, however, the total return, including price appreciation (also known as “capital gain”) matters more than income alone.3
Alternatives to investing
There long have been and still are alternatives to investing in stocks and bonds as a way of storing and making use of idle money. There is saving in the bank, of course. There your money earns interest (which is a positive return), but it’s modest, and these days, less than modest. Stable-value funds, which sometimes appear in retirement plans, are another vehicle for getting a safe interest rate. Money market checking accounts and money market mutual funds are safe on the whole, though the risky mismanagement of a few of the latter could not remain disguised during the depth of the 2008-2009 financial crisis.
To an economist, all of these things, even bank accounts, are investments, because by his definition, an investment is just a resource that is not immediately consumed. But I’ll defer to popular usage: Henceforward, I’ll let “investment” refer only to a financial vehicle that offers the prospect of appreciable growth in value, like stocks and bonds and the mutual funds that invest in them, and derivatives, private equity, venture capital, and hedge funds.
You might think that bonds that have zero or very low risk of default are yet another safe alternative to investing. But that’s only on the assumption that you’ll spend the proceeds when the bond matures; if you cash out before then, it’s entirely possible that you’ll do so at a dismal rate of return. And if you buy new bonds with the interest payments you receive in the interim and with the return of principal, you’ll face the reinvestment risk of unfavorable new bond prices. Inflation may chew away at their value. Regardless of any risk of default, you can still lose money in bonds.
Insurance products, which aren’t really investments in our sense, are another relatively secure place to park unspent money. The fixed annuity is one such product: You give the insurance company a lump of cash, and the company, in return, commits to making regular payments to you for a fixed span of years, or for the rest of your life. These days, there are insurance products that blend the characteristics of an investment with the characteristics of traditional insurance products, but the basic idea of an insurance product is that it lacks risk.4 Indeed, the whole point of insurance, as a concept, is to mitigate risk. As a mathematical exercise, you can calculate the return on an insurance product, but there’s little point in doing so. You know in advance that the return won’t make you the cynosure of the country club or reading group in the way that you hope a hedge fund will; you’re forgoing large returns because you want the certainty of having adequate money in the future.
Social Security has characteristics of an insurance product, and similarly is without risk, but unlike bank accounts and insurance, it’s not optional. And it is not an investment. It is primarily a system of transferring money from individuals who are working now to individuals who worked in the past and have reached the age of retirement. It also does not in any meaningful way have a return. A few years ago, during the debate over whether to convert Social Security partly into a scheme of private accounts, which would be investment vehicles, some proponents pointed to the meager returns on Social Security. This was a category error. These critics of the present system were evidently calculating the return that the government was earning on the so-called Social Security trust fund (which provides supplemental funding to the transfer payments). But this was as irrelevant to Social Security’s beneficiaries as calculating the return that an insurance company earns on its reserves would be to the holders of its annuities.5 The discussion of whether to convert Social Security, even partially, from an insurance to an investment system should be based on arguments other than a comparison of returns.
All these alternatives to investing have one thing in common: They lack risk. Well, that’s not entirely true. Banks and insurance companies can fail, politicians can choose not to provide programs or funds to backstop them, and, as you know, Social Security faces a future funding shortfall that politicians may choose not to remedy. But these are unlikely risks, and to live is to be exposed unavoidably to risks, some of them deadly. You can be hit by a car while crossing the street, but if you spend all your time indoors to avoid this risk, you’ll expose yourself to other risks, through lack of sunlight and exercise. You might contract a fatal disease from someone you meet, but avoiding any human contact imposes other costs. Nothing is truly free of risk. All in all, though, bank deposits, annuity contracts, and Social Security, while they stand some chance of not meeting their financial obligations, are by and large free from the everyday risk of financial loss that is inextricably bound up with investments.When we do invest, we’re looking forward to income and growth, and at non-negligible levels. But as I’ve written before, what really matters, ultimately, is the amount of money you have, not the return you earned.6 Earning a 20% return in one year on $1 matters very little, unless it is indicative of an ability to earn a return of 20% a year on a base of, say, $100,000. Return is a measure of relative change in value, but money, not relative change in value, pays the bills.
1. “Know thyself.,” the Greek saying that supposedly was inscribed on the temple at Delphi.
2. For these statistics and much of the history in the preceding paragraph, I am indebted to Julia C. Ott, When Wall Street Met Main Street (Cambridge: Harvard University Press, 2011).
3. Peabody River Newsletter, issue 2, July 2008, “How to Think about Returns.”
4. There is the risk that the insurance company won’t be able to make good on its promises, and this is one reason to choose insurance companies carefully, but defaults are very, very rare.
5. You might be interested in the return on an insurance company’s reserves if you were trying to estimate the likelihood of its making good on its obligations, or if you were considering buying its stock. It is worth noting in passing that the complaint that Social Security’s putative return is too low is in direct opposition to the claim that it’s a Ponzi scheme.
6. Peabody River Newsletter, issue 2, July 2008, “How to Think about Returns.”