|
 ust
as proposals to allow individuals to privatize portions of their
Social Security "accounts" have gained momentum, a piece
of bad — but inevitable — news may have slammed on the
brakes. It was recently reported that for the first time in twenty
years the average 401(k) retirement account lost money last year.
The losses have led many individuals and politicians to second-guess
Social Security privatization. Central to this second-guessing is
the fact that, in investments, there can actually be losses —
particularly if investment decisions aren't made properly over time.
As the market
continued to climb at historically high annual rates over the past
decade, individuals increasingly allocated 401(k) money to stocks,
failing to heed the advice of advisers and marketing materials that
told them to diversify their holdings with debt securities. Now,
after a nasty downturn, these same individuals opened their quarterly
reports to find that money they put into their retirement fund was
actually lost to the market, so to speak. Since it was, for many,
the first time they lost money in the market, it really hit home.
If they were given control over their Social Security funds (which
now never lose to the market) they could find themselves in dire
straights.
But there is
a silver lining here. The 401(k) decline has many people wondering
how much to contribute and where to invest to achieve their retirement
objective — they are now actually looking to diversify. Additionally,
the news hasn't seemed to dissuade President Bush away from privatization.
The special commission he recently appointed to explore ways to
carry out his campaign promise to permit Americans to invest a portion
of their Social Security benefits will have to address some of these
issues.
The
Diversification Lifeline
One of the major issues of Social Security privatization is the
transition issue, or how to move people onto the system from the
present structure. This can be framed in the context of the investment
horizon of the individual investor. For example, a person with five
years to retire very likely faces a different choice than a person
with thirty years until retirement. Investors with different horizons
require a range of returns that they can expect to see in the future.
One way to
do this is to look into the past and calculate the range of possibilities.
If the economy's reaction to policy changes and/or economic shocks
is stable, the past may be a reasonable guide for future outcomes.
By looking back, one may be able to gauge the range of return possibilities
for various asset classes. Once the range of returns is determined,
all the investor has to do is select the asset-class mix that will
achieve the desired mix of expected return and volatility.
Traditionally,
this selection has been based on standard asset allocating models.
However, the expected return and risk characteristics of various
asset classes depends on the economic environment and the policies
being adopted at the time. Thinking of it this way, an investor
who pays attention to the policies being enacted should yield
higher returns and lower volatility than those whose portfolios
use traditional asset allocation procedures.
In short, a
forward-looking analysis may be able to identify future shifts in
the variance of future returns. By anticipating these shifts, a
superior return can be realized for the medium- and short-horizon
investor. This can be done by keeping track of the policies being
enacted that give rise to alternative economic environments.
The Long and Short of It
The historical experience of the U.S. suggests that for the fixed-income
investor, lengthening the maturity of a portfolio produces a higher
return without any significant increase in volatility. The data
also indicate that the likelihood of achieving positive nominal
returns is much higher using equities. As the investor horizon lengthens,
the average return for the holding period hardly declines, yet the
volatility of the returns declines dramatically.
Thus, if faced
with the choice of selecting a single asset, the long-term investor
is much better off holding equities. This has some interesting implications
for the possibility of the privatization of the Social Security
system. The data suggest that expanding the choice of investment
alternatives to include equities will greatly enhance the average
return while simultaneously lowering the volatility of the portfolio.
In practice,
however, there is a time-consistency issue. While it is possible
that a passive strategy may be optimal for an investor with a long
horizon, say 15 years or more, it may not be optimal for the shorter-horizon
investor.
If an investor
had the choice to select only one asset for his portfolio, he would
only have to know the standard deviation and expected return to
make a choice. Furthermore, if the expected return were invariant
to the economic environment, then he could base his choice strictly
on historical rates of returns. But what if expected returns are
not invariant to the economic environment? Could he do better? Yes
he could.
The appropriate
way is to look for sub-periods that provide a clue as to what return
can be expected in relation to the economic environment. This can
be done in two ways. One, the investor can look for periods that
offer a similar economic environment. Two, he can look for periods
that are mirror images of the economic environment. Either way,
he can obtain information as to the asset class that's likely to
outperform in the economic environment that lays ahead.
This procedure
is not one of short-term forecasting, rather it is one of identifying
inflection points that will last for more than one year. This is
a fruitful process that can be easily implemented and will produce
superior results.
Overall, history
has given us an excellent guide to getting Social Security privatization
not only up and running, but yielding high returns for Americans.
|
