Small Investors and the Stock Market

Includes: DIA, QQQ, SPY
by: Eddy Elfenbein

Matthew Yglesias has a thoughtful post on the feasibility of democratizing the stock market. The celebrated Investor Revolution hasn’t been all positives for small investors as we’ve replaced defined benefit plans with 401k plans.

The fact of the matter seems to be, however, that average people have no real ability to invest money in an effective way. I’m a pretty typical 401(k)-holder at this point—a college educated professional who has neither the time, inclination, or competence to do due diligence on the firms I “own” through my investment vehicle.

If only Americans could somehow access free websites, “blogs” if you will, that provided excellent market-beating advice. Perhaps the government should subsidize these handsome, charming “bloggers” with untold millions.

Yes, I’m in the oddball column since I actually enjoy this stuff but most folks simply don’t care what stocks do as long as they go up.

The good news is that I know a person in that situation should invest in index funds rather than try to pick stocks. The bad news is that, per Salmon’s post, it’s not really possible to hedge yourself against tail risk this way.

The obvious answer is that investors can sit out the market and invest in CDs or Treasuries, which are underrated investment. Or at least they were before the 10-year hit 3%, but then we get back to Matt’s point that small investors aren’t participating in the heart of capitalism which is stock ownership.

Let’s remember that broad stock ownership is a relatively new phenomenon. The average American didn’t own stocks, they had savings accounts. The emergence of 401k plans came at the same time as the stock market boom which it naturally helped. The public and policy makers were spoiled by an 18-year boom in equities. Once that came to an end, well…then things don’t seem so easy.

At the peak of the market in 1929, just 2% of Americans owned stock. During the Tech Bubble, it was closer to 50%. That’s a huge change. Even the idea of constantly rising capital gains is fairly new. Stocks used to bounce around their par value and then you’d wait to hear from the board what the dividend was. Now, dividends are dull and everyone puts pressure on management for higher equity prices.

What’s more, the flipside of small investors not being able to manage our own investments in a sound way is that having small investors participate in the market can only serve to undermine financial markets’ role in providing corporate governance and allocating capital.

Now defined-benefit pensions have declined in the private sector for some pretty good reasons. It’s both personally liberating and economically efficient for there not to be an expectation that you’ll work at the same place for decades. But the substitutes we’ve dreamed up—tax subsidies for middle class stock ownership—are regressive and don’t really make sense.

He’s right. The stock market is a great place to invest but its inherent volatility is extreme for smaller investors. The Dow went nowhere from the mid-1960s until the early 1980s, plus an ugly bear market from 2000 to early 2009—that’s a huge part of a person’s post-retirement lifetime. A millionaire can handle it, but it’s very painful for younger investors.

I really don’t know if there’s a good answer. If we give people more choices, that’s a good thing but we have to be prepared that they’re now make dumb choices.

I worked in a brokerage firm with an account for a property management company. Each month, the manual laborers got a small deposit in their 401k from the company. And each month, they all took it out. It was a mockery of the system, but hey, these guys needed the money. They didn’t even know what it was but they knew one thing—it was their money.

Personally, I’d like to see lower taxes on dividend income, but my argument isn’t one rooted in economic growth. Instead, I think it will reduce the market’s volatility and therefore be more conducive to small investors.