Our Dependence on the Stock Market, and Why We Should Be Worried

The Great Stock Myth is the title of an article in the “Atlantic” magazine by Megan McArdle. The subtitle is even more eye catching: “Why the Market’s Rate of Return—and Your Nest Egg—May Never Recover.” The author provides us with a reminder of just how much society depends on investment earnings for our financial health—both as individuals and as a country. The stock markets are the investment vehicle we turn to, and if they are not healthy then we are in a world of hurt.



Investment return from stocks has varied widely over time, but perhaps the defining moment for the psyche of at least a generation of investors was the boom that lasted from 1982 to 2000.

“Americans jumped into the stock market, first tentatively, then eagerly, and finally almost hysterically. Convinced that equities offered an attractive risk-reward ratio, they began bidding up the price of stocks. Stock-price increases fueled expectations of further growth, until by 1999, a Securities Industry Association survey showed that investors expected to earn an annual rate of return of 30 percent. In other words, they expected that by 2010, stock prices would have skyrocketed.”

“Their actual return, of course, has mostly been negative. Over the past decade, equity investing hasn’t offered much of a premium. The market went up (the Dow hit another record high in the middle of the decade). But then it went down again. In finance terminology, we experienced a lot of volatility—the major indexes have fluctuated a lot—but not much real growth.”

“A survey done by ING Direct in March of this year found that, even after a decade of lousy returns and a spectacular market crash, more than a quarter of Americans expect annual returns in the stock market to average 10 to 20 percent.”

The Dow Jones Industrial Average appreciated at the rate of 5.3% compounded annually during the twentieth century, but for long periods it was relatively flat or negative.

What would be the ramifications if we are entering an extended period where returns are lower than even this long-term average?

“If the return on equities really has fallen, this decline poses a big problem for the average investor who planned to stick 5 to 10 percent of his or her annual income into stock funds and retire comfortably. At an annual inflation-adjusted growth rate of 8 percent, savings of just 5 percent of your income for 30 years will leave you with a nest egg big enough to replace almost half your income when you retire. Saving 10 percent will make you really comfortable.”

“But if the return is 2 to 3 percent, you’ll need to save close to 40 percent to replace almost half of your income.”

“Private pensions are heavily regulated to protect workers. But regulation hasn’t stopped the plans from being underfunded, in part because the regulators, who worried that companies would use pensions as a slush fund to smooth their earnings, kept them from overcontributing in flusher times. Even before the latest financial crisis hit, the government-run pension insurer estimated that, on average, plans had less than 90 percent of the assets needed to meet their liabilities. Now those figures are much worse, and workers who have been depending on those pensions may see them slashed if their companies go under and the government takes over their plans.”

“Even that dire picture may be too optimistic. Allison Schrager, an economist who designs investment strategies for retirement accounts, recently wrote on The Economist’s Web site that for private pension funds, the equity premium ‘is often assumed to be between 5 percent to 8 percent. In my experience, risk managers go silent when asked where exactly this number comes from.’ If the future equity premium turns out to be much lower than these fund managers are projecting, the funding gap may be too large for companies to make up—particularly since the gap tends to be largest in recessions, when companies are least able to find the money for extra contributions.”

“And yet the private plans are in good shape compared with state and local pension funds. For decades, politicians have promised lavish pension benefits in return for the support of the public-sector unions—promises that they, unlike their counterparts in the private sector, did not have to cover by setting aside a reasonably large asset base. Now the bills are coming due, and many funds are disastrously underfunded.”

The retirement plans of nearly everyone could be devastated by poorly-performing equity markets, but at least there is still social security to fall back on—right?


Social Security was intended to help maintain the incomes of only the poorest of the population. For the rest it will not be sufficient to retain anything like the pre-retirement lifestyle. But even Social Security is no longer safe from harm.

“Not even the federal government is immune to the market’s gyrations. In the three years after the end of the tech boom, federal tax revenues plummeted from 20 percent of GDP to 16 percent. Many people blame the Bush tax cuts for the entire ensuing budget deficit, but in fact they accounted for less than half of the lost revenue. Most of the change from surplus to deficit came from other factors, most prominently from what the Congressional Budget Office calls “technical” and “economic” change: the government simply collected less revenue during the bust than analysts had anticipated. Wealthy people pay most of the income taxes in America. And their taxable incomes are extremely sensitive to the performance of the stock market—not surprising, considering how many wealthy people either work in finance, or receive compensation in the form of stock options.”

“For decades, pundits have been warning that a time would come when Social Security would start to become a drain on the federal budget. Now it’s happening. In 2010, for the first time, payouts to retirees and the disabled have exceeded the program’s revenues from payroll taxes. Infusions from the general fund are now needed if the government is to keep mailing checks—a situation that is projected to become a permanent, and growing, problem by 2016.”

“That means that Social Security, too, is exposed to the performance of the stock market.”

What does this mean? Do we have a handle on the long-term performance of the markets? Might this low-performance era be permanent? McArdle has several thoughts.

“One possible explanation for this pattern is that the equity premium has eroded. Markets have grown more efficient over time, as more and better information—and the computer tools to analyze it—has become available. Meanwhile, the stock market has democratized. Modern diversified portfolios have reduced some of the risk of holding stocks, because even if a few companies fail, they won’t take your entire nest egg with them. Rather, the failures average out with the successes to produce a relatively steady rate of return. As defined-benefit plans—what your grandfather called a pension—have died off, people have poured their retirement savings into mutual funds that offer this sort of diversification. The deeper pool of money flowing into equity markets means that equities no longer need to offer a higher yield in order to attract money from bond and other securities markets.”

These are rather technical considerations—timidly presented. There may be broader social dynamics in play that could be determinative. It is amazing how poorly we understand our own economy. This is an issue that is calling for further discussion, but very little has been forthcoming.


This degree of dependence on an entity as flighty and erratic as an equity market is troubling. Beyond troubling, is the notion that public servants and pundits are arguing that we must immediately respond to 50 year projections when they have no idea what the world will look like 5 years from now. In other words, we appear to be too dumb to make smart decisions now, so let’s show a little caution, or—if you are a pundit—a little humility.