Rethinking Stocks: Not Nearly the Pot of Gold We Thought

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We all know that the market has had a rough few years, but new research from Bank of America Merrill Lynch suggests that stocks have been producing  disappointing returns for much longer than that. Fifty years in fact. BofA-Merrill chief US equity strategist David Bianco found that when you adjust for inflation, taxes and trading costs the real return on the Standard & Poor’s 500 during the past half century is a measly 1.3% a year. Bloomberg has a story up about it. And CJR blog The Audit wonders why how this analysis can lead to someone to conclude that stocks are a buy, as Bianco does.

Bianco expects the S&P 500 to end the year at 1,275, a projection that’s 11 percent higher than yesterday’s close and 3.3 percent above the average estimate in a Bloomberg survey of brokerage strategists.

Nonetheless, if Bianco’s research is correct, the implications on the 401(k) debate are huge. Here’s why:

I have argued in the past that 401(k) plans just don’t work as our nation’s primary savings vehicle. But this underscores the point. The 401(k) system is heavily reliant on high stock returns for the scheme to work. That’s what the plans have been sold on. And in response, most people fill their 401(k)s with stocks and keep that money in the market long after they should. That’s because the small amount a year that most of us put away has to grow relatively fast in order to get to an amount that will pay our living expenses in our golden years. When stocks return 10% a year, the 401(k) system works out. When stocks return 1.3% a year, we’re all eating cat food. And remember stocks returned 1.3% in a time when the US was enjoying in general a period of great prosperity and world dominance. What could the next 50 years be like?

The thinking is that one or two bad years will over time get balanced out by years, like 1997, 1998, 1999, when the stock market produces double digit returns. But if this study is right, stocks can produce far less than we expect for far longer than we thought. Most retirement calculators are set by default to assume an 8% investment return. Reset that to 1.3% and you see how silly the 401(k) plan is.

Adjust the 1.3% for the tax-deferred status of a 401(k) and here’s the said truth: If you are 35 and make $100,000 a year, and are lucky enough to have already accumulated $100,000 in your 401(k), you would have to save $114,000 a year to be able to replace 75% of your income in retirement. You read that right. That’s $114,000 a year, or $14,000 more than you make before taxes. Good luck with that one.

And if you are thinking this just means I should be loading up on something else, like real estate, and not stocks (although I don’t who would be thinking that these days). Studies have shown that over the long-haul real estate just barely tops inflation, add in repair costs and the real return of real estate is negative. Bonds over the past 40 years have outperformed stocks, but take out the last decade and that outperformance disappears. A recent study by Barclay’s found that bonds only outperformed stocks in two of the past 8 decades. Every other time stocks handily outperformed bonds. In 1949-59, for instance, stocks rose 16.4%, after inflation. Bonds in the same period fell 2%. Clearly we need some other system for accumulating wealth in retirement. Relying on investment gains alone is not going to cut it.