The 401K Dilemma

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The 401K Dilemma

If you open a long term chart for the Dow Jones from before 1960 to the present you will quickly notice a marked change of behavior post 1980. The chart is ascending slowly but steadily from 1960 to just after 1980. Then the slope increases and gets steeper still. Not only does it get steeper and steeper, it becomes more jagged. From 1980 to the peak in October 2007 the Dow goes from 785 points to 14164 or 1700% growth. Did America's economy grow 18 times larger or its population increase by 18 times? No. This phenomenal growth is due in large part to the increase in liquidity into the markets. Of course a lot of America's top companies have increased their international presence and are returning profits in foreign currencies. But their share value growth has seemly outstripped this.

The 401K can take some of the responsibility for the exponential growth. It came into effect in the early 1980's which happens to be around the time the share markets started to boom. When workers entrust their retirement money to investors they want to see returns better than the bank. Currently the average dividend on Dow Jones component shares is around 2.66%. Interest from banks on fixed term savings are around 0.6% to 0.9%. So shares would make a better investment assuming market stability. But the real attraction in shares is their ability to realize significant capital gains. And they have certainly done that.

Capital gains are often seen as a form of larger foolish investment. You buy something in the hope that around the corner there is a bigger fool waiting to buy it from you. Reliable wealth comes from income producing assets. Business profits, salaries and wages, royalties from intellectual property, rents, dividends and interest are all forms of income. They are certainly not assured as market forces will always dictate what is worthy and what is worthless. But they come from fulfilling certain needs and wants in society and are usually more stable. Significant capital gains on the other hand are temperamental and rarely to a certain extent on hope, desire and greed.

There is nothing wrong with getting capital gains from your investments. But focusing on them is the wrong way to assess the quality of an investment. If an investment pays an income you can measure objectively: for instance how long before your investment has paid for itself. And if it is returning enough you can budget to live off or reinvest the returns without eating away your capital.

Now returning to 401K or superannuation. If your retirement funds are tied up in the share markets you may see phenomenal growth when markets rise and also phenomenal depreciation when they fall. The issue is that the liquidity (extra money) that comes from funds creates huge demand for the finite number of shares. Your investment is inherently relying on continued demand. In all markets where there is a surplice of money there is inflation. Things become overvalued. If the liquidity dries up and the bubble bursts you soon find yourself left with very little value, as happened in the sub-prime mortgage crisis. You need to take an active role in deciding when and where your money is placed to avoid being caught in the next bubble.

The smart investor will look at the markets as cyclic. This is due to money flow. When interest rates are low money flows into the markets and the value of shares and property over-inflate. When the interest rates go up the share and property markets correct. This is exacerbated by the huge amounts of capital held by investment funds and their ability to move it into and out of markets at will, usually in response to reserve bank rates and other market forces. You need to think counter intuitively. When interest rates are high look to buy quality shares and property but wait till you see strong evidence of deflation. When interest rates are low and inflation is climbing looking to sell, especially when the talk on the street is that interest rates may be about to go up. But if you find an investment that is returning 5-10% or more on its purchase price keep hold of it for as long as it does this regardless of the capital gains and market fluctuations. As long as it is generating income and its balance sheet is good it will always bounce back when the market recovers. Quality should always be assessed by taking into account business fundamentals and rate of return on investment.

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