Apple Pie, Economic Growth &
Fatal Stock Market Flaws
Daniel R. Amerman, CFA
(The start of this article is an excerpt from Chapter Three of "Contracts With Our Children", which is the first book of The Great Retirement Experiment series. This article is also available in audio form.)
Consider a fresh, hot pie. Let's call it an apple pie, though it could be blueberry or cherry pie if you prefer. That pie smells delicious, you are hungry, and you want a big, fat slice of that pie. The problem is, so do a lot of other people. How big of piece can you eat? That depends on three things: how big the pie is, how many people want a piece, and whether some people are allowed bigger pieces than others.
Let's call that pie the national economy. The United States economy is what we will be talking about here, but this applies to pies of other nations as well.
Now the marvelous thing about economic pies is that in a growing economy they just keep getting bigger, year after year. Getting a big piece of that pie in the future for ourselves is the motivation for investing of course. We all want the fattest slices of that growing pie we can get, and fortunately there are plenty of people willing to sell us future pieces of that pie or tell us how to get a bigger slice.
How big is that succulent pie going to be? Various reasonable long-term rates of return for our investments are suggested depending on the source and investment type, but a nice one is 10%. The 10% could be a good number, not just because it is nice and round, but it represents roughly what a particular type of calculation tells us is the long-term rate of return in the stock market. We take $1,000 today, invest it for 30 years with annual compounding (reinvestment of our earnings as we get them), and that $1,000 sitting in a tax-deferred account becomes worth $17,449! That is the stuff which financial planning is made of!
The Economic Pie
Another way is to look at the economic fundamentals of our pie. Buying investments does essentially mean that we are buying an ownership interest in the economy. When we buy shares of stock, we become owners of the corporation. The economy is primarily made up of corporations. By collectively owning those shares of stock, we as all the investors effectively own the private economy.
Over the long term (1950-2000), the United States economy has been growing at about 3.5% per year, after removing the effects of inflation (source: Bureau of Economic Analysis). Of that about 1.2% a year can be accounted for by population growth (source: Census Bureau). So we have real growth - per person -- in the economy after inflation of about 2.2% a year. Now, take that same $1,000, and grow it for 30 years at a 2.2% rate, it becomes worth… $1,921.
Hmmm… seems like there might be a problem there. We buy investments expecting to earn a 1,645% profit over 30 years, from our ownership interests in the economy. But the overall per capita economic pie has only grown 92%, after accounting for inflation and population growth. So our expectations for growth in investment wealth are eighteen times larger than the growth in the real economy.
Pie Problems
I think you can see our pie problem. Which is the difference between looking at pies, and actually eating pies. Around fifty million Baby Boomers are planning on eating nice slices of a really big investment pie at some point down the road. Not just all the people who buy stocks and other investments directly, but all those who buy through their retirement accounts, and indeed, anyone who is planning on getting a pension as part of their retirement.
The problem is that when we add up all the different expectations for our future pieces of Investment Pie, and compare them to what the total Economic Pie is likely to be - there just isn't enough pie to go around. An individual can certainly earn a particularly fat slice of the pie, so long as they follow an investment strategy that works out very well indeed. As many investors have in the past. However, how can everybody who follows the conventional investment strategies all earn those big slices simultaneously? How can one sixth of the entire population simultaneously have their real worth increase 18 times faster (1,645/92) than the real per capita worth of the nation itself?
It looks like we have a problem. The amount of real wealth in terms of resources, is growing far, far slower than people's perceptions of their current and future wealth, as valued by their investment portfolios. We have a huge group of people planning on actually selling those investment portfolios to get real resources, at the same time, year after year. How do we make it all add up?
The simple answer is: they can earn that wealth on paper, but when it comes to real resources, they can't cash it out. A pie, or an economy, is made up of the sum of its slices. When most of the people are all expecting their own slices to grow far faster than we know the overall pie is growing - an awful lot of people are likely to be very disappointed.
Historical Returns & Hypothetical Behavior
As long as we are asking questions, this is probably a good place to ask another: if a 10% investment return rate and 2.2% per capita economic growth rate are both based on long term history - what's the problem? Obviously they can coexist, so why worry?
That answers to that question are what the rest of Chapter Three explores, and unfortunately there isn't room in this article to fully address those questions. However, a short answer is that the issue is not whether can stocks can earn a 10% nominal yield while the economy is growing 2% on a real per-capita basis. Because that can work just fine, and has many years in the past. The issue is all the clever people who looked at that 10% yield, and said: "hey, we just found a magic money machine! All we have to do is assume 100% reinvestment of our investment earnings, through our pensions, investment funds, IRAs and Keoghs, and all of society together can become fantastically wealthy! And we can run models using hypothetical investor behavior to prove it historically!"
Now, the problem with that approach, which underlies most long term investment planning today, is that the 18 to 1 figure isn't so much based on historical earnings as it is the hypothetical compounding. All we've really done is demonstrate that exponential compounding is a powerful mathematical concept. If we take an equation with high growth rate - let it run wild with no constraints - then the math proves that we all become wealthy. Keep going in time, and the same math necessarily also proves that our wealth will grow until it is larger than the universe itself. Uh oh. See, that's the usual problem with running exponential equations without outside constraints, and the reason these equations are used with great caution in fields other than finance, or subjects other than our collective life savings.
Unfortunately, there are constraints, and cashing out real goods and services requires a real economic pie. Real financial history is that that never before have we had so many people planning on actually eating such nice big slices of pie, over such long retirements. People generally didn't live that long in the past, and the ownership of securities was concentrated in a much smaller segment of the population. We've made three big changes with our hypothetical investment models, which actually didn't happen in history. Number one, never before have we had so many people investing in the markets, with such a large percentage of the population as investors. Number two, long term exponential compounding of our wealth was not the objective - or the majority behavior. Number three, and this is the most important part, never has such a large segment of society attempted to simultaneously convert such high compounded wealth expectations into real resources, for year after year, over a period of decades. We have never seen anything like this three way combination, and the ability of the markets to withstand this unprecedented test while delivering high rates of return is unproven theory.
This is the end of Part I of Apple Pie, Economic Growth & Fatal Stock Market Flaws. In Part II, we start with the example of a single small city with unaffordable retirement promises, and then expand to take a look at how we expect the markets to simultaneously bail out all the governments, corporations and individuals over the years to come, with the magic of exponential compounding paying for promises and expectations that would otherwise be economically unaffordable. We search for Santa Claus, and pose simple but awkward questions as: who (specifically) buys all those compounded investments, with what (specifically) do they buy them, and why do they buy the investments at those prices?
Picture an interconnected world of 77 million Boomers who are demanding tens of trillions of dollars from the generations behind them for Social Security, and more tens of trillions for Medicare - even as the 50 million Boomers who are investors seek still more tens of trillions from the expected sale of their investment portfolios at the highest prices in history. Picture a world of many tens of millions of younger workers, entrepreneurs and investors at the peak of their own careers, using all of their creativity and intelligence to find ways of holding onto the wealth that they are creating, instead of passively and obediently passing it over to retirees. Picture your investments as part of the back and forth struggle between the generations that will determine how the entire Great Retirement Experiment is really going to work (instead of just the promises that the Boomers are making to themselves today). Picture yourself reading the remaining three quarters of Chapter Three, "Pie Slicing & Missing Trillionaires", as well as the rest of the book. Picture yourself going to The-Great-Retirement-Experiment.com and taking advantage of the books, articles, pamphlets, and audios, that together explore what happens when the stratospheric symbolic wealth expectations of the Boomers and their pension plans wrestle with the reality of limited real resources and self-interested investors, in a title bout refereed by Adam Smith…
Daniel R. Amerman is a Chartered Financial Analyst with MBA and BSBA degrees in finance, and almost 25 years of professional experience.
25 April 2007
Contact Information:
Dan Amerman
Website: http://mortgagesecretpower.com
E-mail: mail@the-great-retirement-experiment.com
This essay and the websites, including the pamphlets, books and audio recordings, contain the ideas and opinions of the author. They are conceptual explorations of general economic principles, and how people may - or may not - interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this website does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, recordings, books and other products, either directly or indirectly, are expressly disclaimed by the author.
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