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The volatility in the stock market is unnerving. After all, Wall Street traders now consider a 2% swing in the market a quiet day. The market's hairpin turns are forcing many individual investors to question whether equities make up too big a portion of their portfolios. The volatility should also raise cautionary public policy questions about proposals to partially privatize Social Security and allow workers to invest a fraction of their payroll tax in the stock market. The privatization idea is often pitched as a way that workers can earn lush stock market returns on some of their Social Security dollars. But higher returns come with higher risk -- a market axiom well worth remembering after the record stock market showing of the past several years.
To be sure, over the long haul, stocks have bested bonds and bills by a 3.5- and 4-percentage-point margin after adjusting for inflation. Yes, some two centuries of U.S. stock market history suggests that the risk of owning equities compared with that of bonds and bills shrinks with time. But the risk associated with owning equities doesn't disappear. To say that stock returns beat out bonds and bills over the long term implies that bonds and bills can do better than stocks for lengthy periods.
Financial history confirms that insight. For instance, bonds outperformed stocks from 1831 to 1861, a 30-year period that spanned the invention of the reaper by Cyrus McCormick to the beginning of the Civil War. From 1870 to 1900, stocks were bested by railroad bonds and did no better than commercial paper, according to Jeremy Atack and Peter Passell in A New Economic View of American History.
"REQUIRED READING."
Another telling and more recent example comes from a study by Steve Leuthold, a well-known portfolio manager and market historian. Leuthold counts 20 bear markets over the past 100 years with an average stock market decline of 36%. The key question he asks is how long did it take for the investor in risky stocks at the market peak to catch up with the investor in riskless Treasury bills? The longest "catch-up" period was 17 years, measured from 1968 until 1985, assuming all dividends were reinvested (table). The comparable calculation from the 1929 peak was 15 years, and the average catch-up period was five years and one month. "When compared to a riskless rate of return, the stock market can and has been a loser for 10- or even 20-year periods," says Leuthold, adding that his study, "should be required reading for the Social Security equitizing advocates."
What's more, Social Security may be considered the low-risk portion of a person's portfolio. The guaranteed income stream from the financial safety net also offers a number of attractive features, including disability insurance and protection against the ravages of inflation.
Clearly, the national debate over how best to ensure Social Security's long-term financial health is critical. The discussion has been greatly enriched by the various privatization proposals. And it is a national disgrace that millions of workers don't have easy access to a pension plan offering a variety of investment options, such as a 401(k). Nevertheless, it's doubtful that transforming the low-risk Social Security guarantee into a riskier pension plan is the best way to boost everyone's retirement savings -- and shore up Social Security.
THE "CATCH-UP" CALCULATION
This table indicates the time needed for the stock investor to
catch up with the T-bill investor, calculated from bull market
peaks.
Date of Date of Decline Time to Catch-Up*
Market Peak Market Trough Percent
Copyright 2000 , by The McGraw-Hill Companies Inc. All rights reserved.
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