Friday, April 20, 2007

Is a stock market crash coming?

I just finished the book, Rick Dad's Prophecy. I know, I know, it has been around for a few years, but what can I say? I'm behind on my reading.

It has an intriguing premise. Like any intriguing premise, it starts with some well known facts and builds on these facts with a reasonable theory. For those who may not have read the book, the basics are:
  • Due to changes in law and economic forces, there has been a shift from Defined Benefit retirement funding toward Defined Contribution funding.
  • Most employees are ill equipped to manage their investments as required for the Defined Contribution system.
  • Baby Boomers will be moving en mass into retirement in the next few years.
  • The resulting drawdown of Defined Contribution accounts, largely in the form of selling mutual funds, will cause a major market crash within the next 10 years.
  • Only financial education and building your own financial ark based on this education can save you from catastrophe.

If true, the financial basics I've previously laid out in this blog would lead to your personal financial disaster. Specifically, saving, investing in mutual funds, and diversification are painted as unsophisticated financially, and are branded as routes to that financial disaster. Although the author carefully avoids making specific recommendations other than "financial education", his solutions appear to revolve primarily around entrenuership and real estate which result in positive cash flow.

With so much at stake, it makes sense to give some serious thought to these issues. Based on that, let me throw some rambling thoughts at it and seek your imput and ideas on the matter.

At first glance, it makes sense. Boomers have had a big influence on megatrends from the beginning of the boom. Doesn't it make sense they will do the same for retirement? Doesn't it make sense that the impending boomer retirement will cause a sea change in investment cash flows? Certainly, on some level it does.

The question though, is how significant the change will be and what are the alternatives for minimizing the risk or benefiting from the change?

For my money, I'm betting that the sea change will be small compared to the noise in the markets resulting from other events, and here are some of the reasons:

  • Boomers will not all suddenly decide to retire. The process will span over 20 years, and perhaps more if a market decline does occur within the next 10 years.
  • Retiring boomers will not suddenly cash in their chips at retirement. Since most can expect to live 20-40 years after retirement, they must plan for 40 years with fairly conservation assumptions. That means that, in all likelihood, they will continue adding to their investments for many years beyond retirement, taking only a part of the return for living expenses.
  • Due to the necessity of conservative assumptions, most boomers will end up leaving a significant amount of their retirement funding to their kids, who will add to it for their own retirement, 20-40 years away.
  • Globalization will mitigate the effect of the boomers, since world population continues to increase at a dramatic rate and most companies and markets are now global entities.

Don't get me wrong. Ups and downs as well as rotation in the markets are inevitable, but these are based on a multitude of different factors and create noise much larger than any overall boomer effect. Even though the boomer effect may be significant in some segments, such as health care (up) or real estate (down), I believe the overall effect on world markets will be marginal, rather than catastrophic.

But maybe there is a better way. What about the author's suggestions? He seems to imply that real estate will always go up. Certainly not true in the short term, but perhaps it is a reasonable assumption for the longer term. He implies this is not true for the stock market, but aren't the same assumptions reasonable there? Stock market ups and downs are more visible, because of more efficient markets, but doesn't the same logic apply to each? And if the stock market crashes, is it reasonable to assume the real estate market or small companies will be immune to the effect? I don't think so.

The author makes the reasonable assertion that positive cash flow is the key to wealth. But he seems to imply that stocks have no cash flow. What about dividends? He seems to imply that for real estate and entreprueners, the positive cash flow is a given, and is locked in at purchase. Who does he believe will be paying the rents or buying the entrepruener's products when the boomers are devastated in the crash? He seems to imply that leverage makes real estate a good investment. This is quite true as long as the market goes up, but it dramatically increases the risk when the market goes down or the renters can't afford the rent any more.

I don't mean to degrade entreprenuership or real estate. They can be good investments in the right conditions. But I don't see them being immune to risks, or to any boomer effect.

My conclusion is that market ups and downs will happen in all markets. The key is to ride through while minimizing risk and positioning yourself to gain from the volatility. I do agree that financial education is advantageous. If you can effectively evaluate investments, that is a huge advantage. But financial wisdom starts with saving, diversification, and maximizing return while limiting risk. I believe the systems I've outlined in previous posts is the best way to get there.

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