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Beyond Buy-and-Hold #87

I put forward some startling words in the column from three week?s ago.

I wrote: ?See a return of 5 percent for each of the first 10 years and you will at the end of 30 years have a portfolio value of $998,579. See a return of a negative 5 percent for each of the first 10 years and at the end of 30 years you will have a portfolio value of $1,739, 987…. In both cases, the annualized annual return is 6.5 percent. The returns are not really better in an overall sense in the second case. They are just a whole big bunch better for you, the investor.?

Can it be so?

If the returns are the same in both of the scenarios described, how can the investors in one of the scenarios be left better off? Where did the extra money that found its way into their pocket come from?

The money comes from investors who sold stocks in the time-period shortly prior to the ten years of losses. The point made in that column is accurate. Smart investors who will be buying more stocks in coming days want prices to drop so that they will be able to buy those shares at low prices. But the opposite is so for investors who will be selling stocks rather than buying stocks. Investors who are selling stocks should want prices to rise.

How bull markets transfer wealth

Bull markets do not generate wealth. Bull markets transfer wealth from one group of investors to another. If there were no bull markets, there would be no bear markets. Stocks would at all times offer a return in the neighborhood of the stock return justified by the annual productivity growth of the overall economy — something in the neighborhood of 6.5 percent real. But bull markets transfer huge sums of wealth from one generation of investors to another. To the great detriment of the overall economy.

I explained in the earlier article that today?s investors will be left $700,000 richer at the end of 30 years if we see 10 years of 5 percent losses rather than 10 years of 5 percent gains. Losses mean lower stock prices and lower stock prices mean a better deal for investors still in their stock-buying years. But say that you were planning to retire in the near future and were taking money out of your portfolio every year in preparation of that. Lower prices would hurt you. Those getting out of the market really do want to see high prices. For obvious reasons. As bad as high prices are for buyers, they are just that good for sellers.

I don?t mean to suggest by these words that it doesn?t matter too much in the grand scheme of things if we have bull markets and bear markets or not, that stock investing is a zero sum game. It matters a great deal.

Stock investing is NOT a zero-sum game

Consider what happened to the tens of thousands of people who started businesses in the early 2000s. These people determined by looking at the numbers on their own portfolio statements that they could afford to take this risk. Perhaps one entrepreneur determined that he needed to put aside $600,000 before taking the leap and, when he achieved that goal on paper in 2000, he handed in a resignation from his high-paying job. Would that person have handed in the resignation had he known that the real. lasting value of his 2000 portfolio was only $200,000? Not if he had a responsible bone in his body.

This entrepreneur has now learned that he has zero chance of being able to make a profit after the huge drop in willingness to spend we saw with the market collapse. Those years of building a business — years of effort that would have benefited all of us if our economic system were being run according to free market principles — were wasted.

Some new entrepreneur may come along with the same idea 10 years from now and make it a success. But he will have to start at ?Go.? The eleven years of hard work and planning invested by the first entrepreneur, the one who deserved the success and would have obtained it had only accurate numbers been reported on his portfolio statement, produced zilch for both the entrepreneur and all the rest of us.

The full truth is that we are all little entrepreneurs, we are all You, Inc.?s. And we are all busted. We planned our financial lives according to the phony, baloney numbers on our portfolio statements and thus made bad decisions about what sorts of houses to buy and what sorts of cars to buy and what sorts of vacations to go on. How can anyone effectively plan for his financial future when the numbers he is using are as wildly off the mark as those we were all using in the late 1990s?

Someone made a killing through our misfortune.

It wasn?t businesses growing their wealth by competing in a free marketplace.

It was businesses profiting from the phoniness of the wild bull and the dangerous and irresponsible investing strategy (Buy-and-Hold) on which it was built.

Rob Bennett believes that saving too much is a big problem. His bio is here. For background on the Big Fail of Buy-and-Hold and on the need to move to Valuation-Informed Indexing, please check out the ?About? page at the ?A Rich Life? blog.

( Photo from Flickr by Helico )