The prevalent transition within the financial markets of the past few decades has been money shifting from active to passive funds. This shift is beneficial. It reduces the drag of fees on the individual, and it empowers the collective market. The diversification of index funds and the American economy allows investors to protect themselves against inflation in almost all of the industries to which they are susceptible. Investors should work to seize these defensive opportunities.

An investor that spends a lot on air travel would be prudent to overweight their allocation to airline equities, but the average investor is well served by an index fund. The automatic diversification of an index fund condenses diverse factors into just one: the investor's time horizon. More immediate liquidity requirements shorten this horizon and increase the chance of selling at a loss. Retirement funds seeking returns in public markets are therefore best left to compound over decades.

Investing in passive funds for market returns is also the only systemic solution for retirement. Not everyone can generate market beating returns, and continuing that performance over decades has vanishingly small odds. Investors can easily replicate the performance of passive funds, and doing so benefits society by aligning interests. Similar asset allocations normalize profits among different investor populations. The result is a unified bet on society at large; people share society’s increase in wealth and work together to compensate for losses.

Besides uniting diverse populations, passive investing removes uncertainty by reducing variability. It’s easier to plan for the future if you can estimate future requirements using historical returns. This clarification is a paramount necessity today. Estimates from the past were not made prudently. Pension funds have increasingly expensive liabilities, a trend that is sure to continue. The WSJ reported that public pension funds were underfunded by 28% in 2016, up from just 15% in 2006. 1 Pension funds have been increasing their allocation to equities, which offer variable and therefore riskier returns, to meet these obligations. These riskier assets allows funds to increase their projected returns, which shrinks their level of unfunded liabilities. In other words, their current level of indebtedness is based on a subjective accounting number. The current subjective accounting number for pension plans across the country is 7.25%, but returns from the past two decades have not met this target. The ten year return was 6.79% while the twenty year return was 6.49%. 2 These funds have been too optimistic, and they’re about to repeat the same mistake. As of early 2018, pension funds expected the following long term returns: 3.2% for cash, 4.9% for bonds, and 8.7% for publicly traded stocks. Federal Reserve rate increases have pushed the three month treasury yield from 1.4% at the beginning of the year to around 2.3%, but that's still far short of estimates. There is also the possibility that the Fed will decrease rates to combat the next recession, making the expected cash return even less likely. The average yield for investment grade corporate bonds is less than 3.7%, which means that the desired bond return is only possible if funds increase their allocation to riskier junk bonds. Excessive risk taking however, is not an investment goal for pension funds. 3 Publicly traded stocks have managed a 10.2% annual return over the past 90 years, but stocks are much more expensive now and will likely have lower returns. A good estimate from PhilosophicalEconomics.com places long term returns at only 5.9% annually. 4 Inflation could increase stock returns, but any price increases will consequently lower fixed income returns.

Government debt is the investment closest to risk free. Everything else must increase compensation to balance against risk. The 10 year treasury was around 8% in 1990, falling to around 5% by 2000, while today it yields around 3%. Not only did past twenty year returns fail to meet projections in an environment with much higher risk free yields, credit risk has risen as it has become easier to beat risk free returns. The lowest investment grade bonds (BBB) made up around 25% of the bond market by value in 2000. Since then, these almost junk bonds have risen to account for 40% of the market. 5 The market's debt is likely worth materially less than par, but interest rates have kept prices high. Expectations for future returns should be lowered as debt prices fall to include this slip in quality. Equity prices are similar. Multiples are high compared to cash flows. Valuations today are in the 97th percentile of all valuations in history and the 83rd percentile of valuations over the last twenty years, which has been a period of historically high valuations itself. 6 These aberrational valuations grew during a period of low interest rates, lowered credit quality, and increased participation in equity markets by smaller investors. The current percentage of household financial assets allocated to stocks is 56.3%, higher than the historical average of 45.3%, and a hair lower than the 56.8% at the top of the market in 2007. 7 Multiples may increase if these trends continue, but that looks unlikely. Interest rates and credit quality are so low already that they’re more likely to be pressured back to their historic means.

The trend least likely to reverse is household equity allocations. Families no longer consider housing a foolproof investment, banks are more particular about issuing mortgages, and the lack of construction since the crisis has reduced inventory. The easiest way for retail investors to invest in credit is through exchange traded funds, which limits personal ownership. Equity is left to make up the difference. However, consolidation and costs imposed by SOX have been limiting investment options by shrinking the number of publicly traded companies. The companies left are bigger and more profitable. That means at least some of the increased stock allocation and the corresponding increase in valuation is warranted.

There are two ways to earn money from equity. The first is dividends paid from the company’s cash flow. The second is selling the stock to another investor for more than cost. This capital gain is created by the purchasing investor because they are willing to pay more for the company’s future cash flow than the seller. Assuming that both the seller and buyer are rational, their exchange is grounded by risk and return. The seller thinks that marginal returns past the time of sale are too difficult for their risk profile, while the buyer wants to take the risk. The alternative, sales to investors who can’t afford the risk, is speculation that can result in a bubble. Essentially, sustainable capital gains require buyers who can afford, because of their income or assets, to take a less favorable risk reward ratio. With valuations in the 97th percentile, there are few investors left who can afford to create them.

The volatility of capital gains illustrate a powerful caveat to equity compared to debt, which has fixed returns if held to maturity. There is more room to make mistakes. As of 2014, investors lagged behind the stock market by 1.3% annually between 1926 and 2002, while investors in mutual funds earned one to two percent less than the funds themselves. Even large sophisticated investors like pension funds earned an average of 3% less than the hedge funds they invest in. 8 It looks like every type of investor is prone to buying high and selling low, but that’s actually good news. Since even professional money managers consistently make this mistake, it’s not a function of heft. Instead, the ability to buy low and sell high can best be described as mindfulness.

Part of this mindfulness is an investor’s understanding of their risk profile. Avoiding too much risk allows them to invest without premature liquidity requirements that force losses. And while the diversification of an index fund helps an investor stay within the bounds of their risk profile, it helps to be wary of a fund's drawbacks. Funds are not just as risky as their individual components. The constant drag of fees and taxes must be considered. Capitalism's strength stems from the influence consumers have on producers. Increased distance between the two, like offloading responsibility to a third party, reduces positive outcomes. The SP500 just recently moved Facebook and Alphabet to a new sector, reducing the old sectors capitalization by 21%. Less than half of that value was moved by investors to follow the change. The value that wasn’t moved was presumably invested back into companies in the old sector. 9 That increase in value is arbitrary and likely to reverse at the expense of those not paying attention. Third parties also socialize the costs of herd mentality. When investors chase gains at the top of the market, managers are forced to buy at high prices, reducing gains. When the market turns and investors lose their nerve, managers are forced to sell at prices that have an increased chance of gains. Additionally, any capital gains triggered by the sales have to be paid by the disciplined investors that stayed. 10

Completely passive investing has two other important drawbacks. The first is that resource allocation is based on past results. Proportions based on market cap assume that the largest companies will continue to do well, which is not guaranteed. This leads to the second drawback, a perverse incentive that threatens the benefits of passive investing for society. Common ownership of stocks can result in systemic, mainly government, protections that reduce economic dynamism. As mentioned before, increased consolidation in the economy has resulted in fewer but more profitable firms. The government taxes profits. Public debt is booming, and some of it - like public pensions - is protected from default by state constitutions. It shouldn’t be surprising that regulations have tended towards cronyism; the government is protecting its ability to pay its obligations. Of course, you lose leverage when you depend on so few suppliers. The too common result is a company threatening to move and getting tax breaks, which just increases the tax burden of smaller businesses.

While the government financially engineers tax revenue through consolidation and inflating multiples, the responsibility falls to citizens to realize that true progress can only be achieved through political action. The same types of leaders have been re-elected, despite achieving nothing, because we allow them to stoke tribal antagonism and taint good ideas. Citizens must unite to end the unaffordable status quo: protecting profits at the expense of individuals, unsustainable entitlements, and ignoring the death of the environment.

Long term stock market returns can be roughly predicted as the sum of economic growth, inflation, and dividends. For an investor to realize returns they need to have cash in hand. Returns from dividends are immediately realized, but the other two components are locked in a company’s book value until purchasing investors release them by creating capital gains. Since capital gains require an increase in the ability of the market’s investors to shoulder risk, effective political actions should focus on economically empowering the individual. There are two ways to accomplish this: lowering costs and increasing incomes.

There are obvious problems impeding this progress, but voters have allowed leaders to ignore them. The education system is too expensive and has done a poor job preparing students for high value degrees. Only 49% of 2018 graduates who took the SAT met the benchmark indicating they would succeed in a first-year college algebra class. 11 That same benchmark was only met by 40% of the graduates who took the ACT. 12 The result is students in debt to obtain a low value degree, or even dropping out without graduating. Housing barriers enrich people that already own property at the expense of those that don’t. Healthcare prices are drastically inflated because of the distance between consumers and producers. Instead of individuals, the real customers of healthcare are insurance companies, employers, and the government. The high variability of outcomes between inner city and elite private schools, as well as the refusal to treat drug abuse as a medical issue endangers everyone by encouraging crime. Technology could streamline government operations and enable commerce between everyone on the planet for zero marginal cost, but policy makers have largely ignored its potential.

An investor's ability to take on risk, which comes from their economic empowerment, manifests in their valuation of an asset. Understanding this valuation allows investors to compensate for the drawbacks of passive investing. For example, even the least empowered individual can engage in arbitrage because the arbitrageur doesn't take on risk by placing a valuation. They simply profit from the valuation differences of other investors. Alternatively, any valuation placed on an asset through public trading is the result of every purchasing investor's combined ability to take on return and risk. Again, this ability is ultimately dependent on income. So why does JPM stock trade at price to earnings multiple of 13 instead of 7, or even 1? It's because investors think other investors have the ability take on increased risk for JPM's upside. If incomes plunged, people would be less and less willing to pay for the upside, lowering the multiple until the stock is free money. The composition of all of these factors are volatile, but that allows prudent investors to profit when prices fall below where investors can support them.

Take a look at the following graphs of JPM for a quick example of valuation analysis.