Monday, June 27, 2011

Social Security and Our Investment Choice of Stocks vs. Bonds .... an Overview


There's a real and somewhat silly ongoing debate about whether as individuals we can be trusted to save for our own retirement security or whether we can instead look to future generations to pay our way. How much future social security should pay retirees, in other words, and who should pay for it.

Some suggest that since we don't save enough as individuals to take care of ourselves in retirement, we should simply raise the Social Security entitlement payments and send the bill to the grandkids. Another argument suggests that we should finally acknowledge that social security insurance really isn't insurance at all, despite what it's been officially called since its enactment in 1935. We could then call it what it really is ...... another entitlement and income redistribution program. Then we could make the highly paid workers "contribute" (the honest word is tax) even more into the "fund" (there is no fund) and pay for the social security insurance (again, there is no insurance) that way.


But this isn't about the fiction we call social security. It's about our future personal financial security, no matter wherefrom. Due to the fact that somebody needs to save and invest or there won't be sufficient funds in the future, it's really up to each and all of us, one way or another. The free lunch underfunded entitlement approach has been tried and found lacking time and again. And if tried yet again, it will inevitably come up short ..... again. In the end, somebody has to pay. And that somebody is "We the People".

So let's discuss the pros and cons of investing our individual savings in stocks or bonds, recognizing that first there have to be savings in order to have funds to invest.

When investing, asset allocation is critical. Asset allocation simply means what portion of our investment goes into each of the available investment instruments. We'll restrict our choices herein to stocks and bonds. And we won't concern ourselves with diversifying among the two asset classes. In fact, my view is that for the long term investor, today's historically low interest rate environment argues for an all stock portfolio with no bonds, but we'll defer that "no diversification" discussion for now.

Let's compare the two choices and why stocks are clearly preferable to bonds for many years to come. We will not adopt a trading approach to investing but rather will choose the "old fashioned" buy-and-hold system. Both history and logic dictate that buy-and-hold is the optimum approach for those who are focused on the long haul, which we are. A long term buy-and-hold investment strategy is not exciting, but it is the best way to a secure financial future.

We'll also look only at tax free investing currently (401k/IRA). Also, transaction costs (brokerage, bank or money manager related) or other often "hidden" costs aren't part of the comparison either. We'll deal with all these issues at a future time but for now, it's the KISS method all the way. Besides, when we do at a later time consider taxes, transaction costs, money management fees and the like, the case for the recommended buy-and-hold stocks methodology will be even stronger.

The straightforward bond vs. stock comparison can be illustrated as follows: we have $100 to invest for 30 years; and we're deciding whether to place our money in either (1) U.S. government bonds or (2) a wide variety of blue chip stocks through a Standard and Poor's 500 index fund.

If we select bonds, we'll choose government bonds, since they are the safest of all fixed income instruments.

If we choose a basket of stocks, we'll choose the "blue chip" Standard & Poor's 500 Index (S&P 500). The index is made up of 500 stocks and represents "the market". Firms like Exxon, McDonald's, Wal-Mart, GE, Pfizer, Merck, Microsoft, Intel, Apple, Whirlpool, Pepsi, Home Depot, JP Morgan, Wells Fargo, Caterpillar and Deere are a few of the prominent names on the list.

Back to the comparison.

Thirty year government bonds currently yield ~4%. The current dividend yield on the S&P 500 index is ~2%. Since four beats two, we'd pick bonds, all other things being equal, but, of course, they never are. So let's look closer. Much closer.

If we purchase government bonds with the $100, we'll receive $4 each year for the next thirty years in the form of interest income. At the end of those 30 years, we will have received a total of $120 in interest and will have our initial investment of $100 returned as well. So we'll have gone from $100 to a total of $220. The $220 will probably be worth much less in thirty years than the $100 is worth today. That's due to inflation.

If we choose stocks, despite the daily, monthly and annual ups and downs of the market, over the thirty years we'll likely enjoy a total average annual return of ~9%. 7% will come from stock appreciation and another 2% will represent the current yield on the portfolio's value over time. Thus, we should expect to receive total dividends of ~$82 (the initial $2 compounded at 7% annual growth over 30 years). The stock price should increase from $100 to ~$800, using the same 7% annual appreciation assumption. Therefore, the total dollars in the case of a stock purchase, including dividends received, should be worth ~$882 in 30 years. And $882 in purchasing power then should be worth much more than $100 is worth today. We'll beat inflation by a bunch, in other words.

$882 compares nicely to $220, so we'll choose stocks over bonds.

But that's not all. If our total stock value of $800 is invested in a government bond yielding 4% thirty years from now, when we may need the income, we'll receive $32 annually in interest each year thereafter. On the other hand, if we take the $100 principal from bonds at the end of the 30 years and reinvest it at 4%, we'd only receive $4.

$32 beats $4. Thus, let's invest in stocks for the next thirty years and then consider switching to bonds, in whole or in part, thereafter.

But even that's not all. If our total stock investment return of 9% annually consisted of 7% in annual price appreciation and 2% in dividends, then the $2 in annual dividends will have grown to ~$16 by year thirty.

Thus, in year 31, the stock price would be $800 and the annual dividend would be $16, still representing a 2% current yield. When looked at from a return on the initial cost of $100, however, that's a 16% yield on cost. And it will likely continue to grow from that point forward as well.

In the bond case, in year 31 we would collect $4 in interest on our $100 principal, or 4%.
In the stock case, in year 31 we would collect $16 in dividends on our $800 stock value, or 2%.

That's the magic of compounding accompanied by the magic of ownership. And although in the example it's just math, the math correlates nicely with historical performance. For an additional argument in favor of stocks today, the starting point reflects the current level of historically low interest rates.

All in all, it's a no brainer.

Thanks. Bob.

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