Guest post written by Auren Hoffman
Auren Hoffman is founder and CEO of Rapleaf and venture partner at Founders Fund. You can follow him on his blog (Summation), on Twitter (@auren), and Facebook (aurenh).
Auren Hoffman: Just say no.
It has been conventional wisdom for the last 50 years that if you are a long-term investor, your best return will be in stocks. Almost every financial advisor will tell a 30-year-old to put upwards of 90% of their portfolio in equities.
Most people above median wealth have a substantial allocation of their liquid portfolio in the stock market. Some people pick individual issues (Apple, GE, Wal-Mart, etc.) and some invest in managed mutual funds (Fidelity, say), while others invest in index funds (the Vanguard S&P 500 fund, for instance).
Stocks are less than 10% of my portfolio. This is a long article (read time is going to be at least 12 minutes) but I implore you to read it in full.
“Never invest in a business you cannot understand.” -Warren Buffett
That’s great advice from the Sage of Omaha. But we should take it a step further:
Never invest in a security you do not understand.
So the question is: do you actually understand the stock market?
Prices of stocks seem to be a mystery to even the most experienced investor. There are often market swings of over 1% per day.
Supply and demand
Most investors argue that fundamentals (like expected earnings) drive price. That doesn’t seem to be a complete explanation as we have had a market which has basically remained flat since the late 1990s.
The best explanation, beyond “fundamentals,” for long-term market movements: supply and demand. In this case, “supply” is the amount of total stock for sale and “demand” is the total dollars looking to buy those securities.
The key factor here is the demand. While supply (investible stocks) does change, its change is very small relative to the demand (amount of money looking to invest in the market). So as more money goes into the market, the market goes up. If money is coming out of the market, then the market goes down. It is basically that simple.
To properly be a long-term stock market investor you need to read the mind of the public. You should only put your money in the stock market if you think everyone else will keep money there. So to inform your portfolio allocation, we want to figure out if money is going to flow into the market or leave the market over the next 30 years.
Let’s examine the six key factors why money might be leaving the U.S. stock market:
- 1. Retirement Savings
Retail investors, via their 401(k) retirement plans and pension plans, are one of the largest groups of investors in public stocks.One of the big reasons the market has been flat over the last 15 years (and not collapsed) is because so much retirement money has come into the market. Most of that money is held by people who are close to retiring and will likely be coming out of the market, albeit slowly, over the next 30 years.
Asset allocation would suggest that people should shift away from equities as they get closer to retirement. I don’t have data on this, but I would guess that most boomers still have over 50% of their portfolio (excluding real estate) in equities (even after the 2000 and 2008 crashes). This is way too high. Since many of these people are counting on the retirement income to live, they might flee from the volatility of the stock market and move to safer investments.
Robert Arnott, chairman of Research Affilitates (and an asset manager for PIMCO), recently said: “The ratio of retirees to active workers in the U.S. will balloon. As retirees sell stocks and then bonds to support themselves, there will be fewer younger investors to buy those securities, keeping a lid on prices.”
- 2. Globalization
Globalization has been a huge boom to the market over the last 30 years. Today it is easy for anyone in the world to buy U.S. stocks; America has historically been the safest place to put your money. Because of this, we’ve seen a massive influx of capital from all over the world, and especially from oil rich nations that need to invest their profits in an historically safe environment.
But globalization is a two-way street. While the U.S. stock market has been a huge beneficiary of globalization over the last 30 years, it could be its biggest loser in the next 30. Today, it is becoming much easier for Western investors to invest in high-growth countries like Brazil, China, South Africa and India. And while I personally don’t invest in emerging markets funds (save that for another article), millions of investors will be drawn to the potential returns of these high-growth countries.
Globalization also means increased competition from old entrants as well as start-ups. New companies are disrupting old but profitable businesses – sometimes by giving away core products for free. We see that time and time again, the top companies are getting their lunch handed to them by new entrants. In every major field (including software, computers, energy, retail, media, defense and pharma), established players (those that had the highest market maps) are getting squeezed by the little guy. All this means that the average time a company will be a member of the S&P 500 should drop significantly.
All indications are that as the world gets more interconnected, it is also getting more volatile. We should see many more bubbles and more ups and downs as capital can zip around the world in nanoseconds. This volatility could be the enemy of the buy-and-hold index investor who is at the whim of much more sophisticated global banks.
- 3. Technology companies
In the '80s, '90s and 2000s, tech companies drove a lot of the market growth. Microsoft (in 1986) and Dell (in 1988) went public while they still were extremely fast-growing companies and public market investors were able to ride the growth upwards. Even recent IPOs like Google (2004), Salesforce (also 2004), and Amazon (1997) went public early enough so that investors were able to participate in substantial gains as the companies grew. Remember that Amazon wasn’t profitable until 2001, four years after it came public.
Today, because of the abundance of private equity capital and regulations like Sarbanes-Oxley, tech companies are going public much later in their development. Companies like LinkedIn and Facebook were able to delay their IPO by 2-3 years because they had access to late-stage private equity. And while biotech firms are still going public before they are profitable, we will likely see more and more companies waiting to list. In today’s world, public market investors do not get as much of the benefit of a company's early growth (most of that benefit will be going to private equity funds). So one of the biggest growth drivers of the market, hot tech companies, is being substantially reduced.
- 4. Taxes
Stocks have been a very favorable investment because gains held over a year are taxed at the lower cap-gains rates and the taxable event only happens when you sell a stock (and many people can do tax arbitrage by selling their losers).
Long term capital gains taxes in the U.S. are near an all-time low. In the 1990s and 2000s, we saw a substantial decrease in the rate of capital gains taxes while taxes on ordinary income have remained basically flat on upper-earners.
One prediction we can confidently make: cap gains taxes are not going to go down further in the next 30 years (even though many of us would like them to). More than likely, we will see a rise in taxes on cap gains – especially on the upper-earners who control most of the money in the market. When this happens, stock gains will look less favorable and it will be another reason for people to rebalance their portfolio away from public stocks.
- 5. Interest rates
Can interest rates be near zero forever?
Clearly the answer is no. At some point, the U.S. government will need to inflate itself out of its massive debt. In any scenario, interest rates can’t get any lower. When interest rates rise, future earnings of companies will suffer (and if that is not already factored into the price, stocks will fall).
- 6. You are already over-correlated to the stock market
If you are reading this article (and you have gotten this far), you are probably part of the population whose job is over-correlated with the stock market. If you are in technology, finance, real estate, law, consulting, or in most of the other top-earning professions, then your future income and job security is probably very tied to the stock market.
If you do invest in the stock market, you need to have the ability to ride it out for the long haul (ride the ups and downs). If you are in a profession that is over-correlated with the stock market, you’ll have extra income (you’ll want to buy) mainly when the market is really high and you’ll need income (you’ll want to sell) mainly when the market is down. You won’t be in a position to take advantage of the long-term market trends (and likely that others in the market will take advantage of you).
All this is not to say that you can’t make money in the stock market.
Some professional traders will be incredibly successful. But the traditional “buy and hold” strategy seems like it is going be “hold and lose.” When the stock market fails or remains flat over the next 30 years, our entire society’s savings strategy will need to be recalibrated.
You should only put your money in the stock market if you think everyone else will keep money there. If you think some people are going to start fleeing the market, then you should make sure you flee first.
But I want to make out-sized returns!
The best way to get massive returns is to invest in yourself. Start a business, join a fast-growing company, or become the newest singing sensation. If you believe in yourself and your talents, focus on things you can control rather than things, like the stock market, that you can’t.
Special thanks to Stephen Dodson, Jeremy Lizt, Travis May, Patrick McKenna, Ken Sawyer and Michael Solana for their willingness to debate me on this issue.
