I see stock markets falling in three, possibly more, stages. The first stage is the golden age of capitalism, where owners run and have a stake in their own company. In the second stage operations and stakeholdership is taken over by professionals, that is, CEOs, who own less than 1% of the company, and (institutional) fund managers, who are investing other people’s money. This may be considered a representative democratization of capitalism. Investing has reached a third stage with so-called “index investing”. Index investors care little about what they are buying or what price they are paying. The philosophy behind index investing is to piggyback on the professional investors without paying the fee(*). The idea is that someone somewhere rationally determines the correct value for traded companies and presumably buy them if they are cheap and sell them if they are expensive.

(*) I figure the next logical step would be to fire the CEOs and just do whatever the competitor’s CEO is doing.

This poses a demographic problem for buy and hold index investors that are “in it for the long haul” that has been lead to believe (I won’t mention any names, but throw a dart and you’ll probably hit someone who advocates index investing for the long haul) that 10% annual returns are typical. In fact, US index returns have been flat for the periods of 1905-1942, 1965-1983 and 1998-2008(*). Mind you, there has been lots of motion in the market. It is not that someone decided that the price of all companies was to remain fixed, nor did individual companies not perform great, rather, it was the average trend (index) that went nowhere. Imagine for a while saving $1000 a month starting in 2005 and continuing until 2042 and assuming that the 1905-1942 period repeats. At this time, you would have $456,000. Discounting by 3% inflation, this would be worth $152,750 in today’s dollars which is somewhat short of a standard calculation which usually touts millions! Now, this is not a worst case scenario. It is simply the worst that has happened within the past century. It could be worse.

(*) Note that the good periods started towards the end of world war II and towards the end of the cold war. War war war.

The problem gets magnified, if a bear market hits towards the end of the investment period when the portfolio is largest. This has traditionally been “solved” by balancing the portfolio with a bond component. However, doing that eradicates the presupposed 10% returns. In particular it lowers them during the final decade when they make the biggest difference.

The biggest mistake buy and hold index investors make is to say something like “I don’t care about fluctuations. I’m in it for the long haul.” However, being in it for the long term does not make investing in stock risk free. If this was the case, institutional investors would run arbitrage and bring returns down. With the popularization of index investing in which a majority of investment money gets put into index funds because “that is what worked in the last war” this just might happen. There is no such thing as a free lunch!

Hiding in the herd is fine, but it is important to know which herd or cohort you’re hiding with. This is the demographic problem of buy and hold index investing. Professional investors work on a LIFO (last in, first out) principle. It is essentially the same float that is trading as the they try to figure out the correct price at a given time. Buy and hold investors, on the other hand, work on a FIFO (first in, first out) principle. Those buy and hold investors, who are pulling out their money now, are those who invested 30 years ago, not those who invested last year. This idea can be developed into some sort of LIFO reserve for the stock market similar but not analogous to the discrepancy between the two different methods in inventory accounting (think of the shares as the inventory).

LIFO + LIFO reserve = FIFO

The LIFO reserve is what is being completely ignored when the market capitalization of a company (and by analogy an index) is being valued. To calculate the market cap take the current (LIFO) price and multiply by the total number of outstanding shares. However, aside from the growth (the GDP rate may suffice or 2-4%/year rather than the 10% of the stock market), the shares were acquired under FIFO accounting. If a large cohort (babyboomers) start selling, there will be more sellers (babyboomers) than buyers (generation X), and hence prices will drop and the LIFO reserve will be negative. This means that the realizable value tied up in retirement funds is less than what it appears to be from the LIFO numbers. This LIFO reserve can be estimated by looking at demographical trends.

It would thus behoove those that buy and hold major trends to consider the demographical bumps. Specifically, will there be more buyers (people thirty years younger than you) than sellers (people your age) when you plan to retire. In particular, the presumption that investing is an exercise in autopiloting should probably be revised.

2011 update: A recent paper on how the boomers selling stocks to fund their retirement may hold down stocks for decades has just been published. Glad to see the authorities are paying attention.

Originally posted 2008-04-11 07:17:36.