Tuesday, August 09, 2005

Investing in stocks versus government bonds

Our friend TKC made an excellent comment about Social Security: how much would he have had if he could have invested 12.4% of his income in the S&P 500 since 1987? At first I was just going to do some rudimentary calculations; then I found myself making a spreadsheet with dynamic formulas.

"But, but," the feds insist, "you're too stupid to be trusted with your own retirement!" Hence this funny-but-poignantly-sad cartoon that I got via Econopundit:

If someone's going to screw up my retirement, let me do it myself. I'd rather feel incompetent than betrayed.

Now, stocks are too risky, we're told by Krugman and the other socialist advocates of paternalist government. But as our friend Josh Hendrickson recently pointed out, if you had put money into the S&P 500 in early 1988 and let it sit, how could you have lost?

S&P has historical data for the S&P 500 since the end of 1987. Had you put $1000 in the S&P 500 at the very end of 1987, it would have been worth $4904.97 at the end of 2004. Not bad for 17 years! It would be worth $4963.65 today.

However, that's not what happens when you invest throughout your working life. Most people don't have a large sum that they invest and let grow; usually we contribute a little each month. So I worked on a little model. Click the filename to download it.


It's a fairly simple model based on the S&P 500's end-of-month value from December 1987 through July 2005. You're investing 12.4% of your base salary (your Social Security payroll tax, and your employer's "contribution" that actually comes from you anyway) in a basic S&P 500 index fund. As the header says, you can change the values for starting salary, annual raise and fund fee. The initial values I supplied are meant to be modest: a starting salary of $25,000 (which was pretty good for a new college grad in 1987), a consistent $1000 raise every 12 months, and an index fund annual fee of 0.5% (pretty standard at the high-end brokerage houses, and you might pay less at the discount firms). The formulas are correct, but rounding might create differences of a penny if you check the values by hand.

You'd have peaked at $139K in August 2000, and today you'd be back to $137K. There's a good chance you'll surpass the $139K in the next several months, but even so, you're still way ahead of the $73K that you've put in.

Contrary to Paul Krugman's prattle about risky stocks, a properly diversified stock portfolio will reliably go up over the long term. Again, look at Josh's chart, and look at my spreadsheet: how could you have lost? You could have five Enrons in the S&P 500 and still lose just 1%.

Now let's see how would your money have done in the Social Security trust fund. By law, Social Security payroll taxes are "invested" in low-grade Treasury bonds that yield 3% or so. By my quick spreadsheet, investing the same 12.4% of the same income for 17 years at 3% interest will yield $87K from a $69K contribution (not $73K, because the spreadsheet is 17.5 years, and for the sake of simplicity here we're just using the first 17). Not as good as investing in an S&P 500 index fund. However, some think, government bonds are backed by the full faith and credit of the United States. They're virtually guaranteed investments, so it's worth investing in them instead of "risky" stocks...right?

But there's a problem with the interest: we're making the interest payments to ourselves. The Treasury pays us interest, but the Treasury must get that money from taxes, which we pay. It's like my left pocket loaning $100 to my right pocket. It doesn't matter if my right pocket can pay it back with infinite interest: I overall gain or lose nothing from the interest payments. We must consider the accounting for both sides.

I discussed making interest payments to ourselves, and the overall myth of the trust fund, here, here and here. Now Krugman, who's said to be a Nobel-caliber economist, thinks that the Social Security "trust fund" will still run a surplus until 2028. It's now projected at 2018 instead of 2017 when the trust fund will start taking in less money than it pays out. But Krugman has said the "trust fund" can simply use, as needed, the interest on the bonds it holds. As I said in my entry about the Great Social Security debate, that's citing a figure worthy of Enron accounting. Just where will we get that money, Paul?

[Updated: Oops! I changed the wording in the penultimate paragraph. I referred to links that I implied were already given, when in fact they weren't given till the next paragraph.]


Anonymous Eric said...

One of the statistics I've read is that if you had invested $1 in the Dow Jones Industrial in August 1929 (1 month before the crash), that $1 would have been worth over $700 in 1989. Hello! I'm thinking that means that if you had put $1000 in in 1929 it would have been worth $700,000 60 years later. Keep adding zeros. That's a mighty impressive retirement. And way ahead of inflation. And the DJI is not risky or high growth. Compare that to the complete lack of growth in the money that you involuntarily invested in SSI over a 50 or 60 year period of time.

Tuesday, August 09, 2005 12:13:00 PM  
Blogger TKC said...

Wow! Thanks to Perry for crunching the numbers. I knew it would be a good sized chunk of change, but I didn't think it would be that big. And this sample is not an entire working life time. 1987 to present is only 18 years. I'll make a wild guess that most people will work around 40 years (age 25 to 65). So his sample is less than half. And since the DOW has never declined, EVER, in 40 year period, your retirement investment should snowball.
Come 2018 SS will have to start drawing from the general treasury instead of lending money to it. It is a double hit just to keep current spending levels. The first hit is that they'll have to get more in taxes to cover what the SS fund is no longer lending. The second hit will be the taxes that will have to raised to pay back what SS has already lended. Like any ponzi scheme, this is doomed to collapse. Guess who ends up holding the bag? Everyone paying taxes.
And to think an average worker could have had $130K portfolio as an asset at just under the halfway mark to retirement!!!! Instead we get $70K of a liability. If people only knew this then SS would be voted down tomorrow. Instead, people read Krugman, and are being led into disaster.


Tuesday, August 09, 2005 5:13:00 PM  
Blogger Perry Eidelbus said...

I worked for a couple of years at Morgan Stanley, at a retail branch. We had very nice color charts about stocks' performance to show potential clients who weren't sure about stocks. The best chart tracked inflation, Treasury bonds, small-cap stocks and large-cap stocks. Anyone can eyeball it for just a few seconds to see that both types of stocks are far superior. The key is to diversify.

When I started at Morgan Stanley as an intern, I asked my advising professor if he invested. If he wanted, I could have referred him to a good broker. My professor said he had money in a simple S&P 500 index fund. At the time I thought, "Certainly he could pick something with better returns?" Then I got deeper into the business and learned why S&P 500 index funds are great. They're ultra-diversified, you can maintain your investment for a fraction of a % (versus a professional money manager that will want 1%), and over time the S&P 500 is nothing to sneer at.

S&P 500 index funds are also the backbone of the Federal Thrift Savings Program. Read this piece by Don Luskin for more info. Half of the investment gains came via the S&P 500 fund, though only an average of 30% of the accounts' values were invested that way.

We can read Krugman's inanely pessimistic rantings, or we can read this incredible book: The Morgan Stanley Guide to Personal Investing. I highly recommend it from experience: it's a great primer for beginning investors, and a good refresher for experienced ones. One of its great points is that even had you invested in stocks just before the crash, today you'd still be in great shape. Give the markets time.

Oh, TKC, it's even worse: the last SSA trustees report said that Social Security will need to start redeeming the bonds in 2017. What will we do if it becomes 2016, then 2015? Time's already running out.

But let's follow Krugman's advice and make Social Security solvent by rolling back Bush's tax cuts. That's brilliant, you know, fixing Social Security while at the same time asphyxiating the economy and creating unemployment. One of my earlier blog entries pointed out that Krugman won't dare agree with big liberal (socialist) groups like the Economic Policy Institute. The EPI says Social Security can be made solvent immediately by lifting the cap on payroll taxes, i.e. you and your employer get taxed 12.4% on all income, not just the first $90K. Krugman's rich enough that paying it on his entire income is quite a hit -- and it doesn't have deductions like income taxes do.

Tuesday, August 09, 2005 11:39:00 PM  
Blogger Corey said...

"But there's a problem with the interest: we're making the interest payments to ourselves. The Treasury pays us interest, but the Treasury must get that money from taxes, which we pay. It's like my left pocket loaning $100 to my right pocket. It doesn't matter if my right pocket can pay it back with infinite interest: I overall gain or lose nothing from the interest payments. We must consider the accounting for both sides."

I feel this is the very crux of the SS debate. Even those supporting changes happily compare the current POSITIVE 'return' on the SSA Trust Fund bonds to some theoretical [better] return from alternate investment vehicles. They are all arguing from the wrong baseline! The real return on the SSA Trust Fund is NEGATIVE. It is a debt engine. The more surplus the Trust Fund collects, the worse the future value problem becomes. If the folks advocating changes could stop repeating that often quoted 2.9% average return, and would instead make their comparisons based upon the realized NEGATIVE return to the participants, perhaps public opinion could be shifted. Maybe it could start with the bloggers, and move to the mainstream. Perhaps Perry could figure out what the exact negative return is. Remember to include the managment overhead of the SSA.

Wednesday, August 10, 2005 1:20:00 PM  
Blogger TKC said...

If memory serves me correctly then by 2040 or so the negative return goes over 100%. It is already negative now if you think about it. The SS 'trust fund' is about a $1.7 trillion loan to the general treasury. How can the general treasury pay that back? Only through taxes. Who pays the taxes? You and I. So in order to get that $1.7 trillion in SS benefits we will have to pay $1.7 trillion plus interest in taxes to the general treasury.

It is a scam.

Wednesday, August 10, 2005 4:22:00 PM  
Blogger Perry Eidelbus said...

Corey, Michael Tanner of Cato said in the Great Social Security Debate that the average worker will receive only a 1.4% return on what he pays in.


The 1.4% is only because others are paying for it, i.e. those at the upper brackets of the payroll tax. By definition, government doesn't earn anything on the tax dollars it collects. Even if puts some money in interest-bearing accounts, that's not enough to offset the disincentive of the initial taxes. Bruce Bartlett has mentioned a midline estimate of every $1 in taxes discouraging 20 cents of economic production.

Saturday, August 13, 2005 6:12:00 PM  

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