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Our Love Affair With Stocks

Cover Story


The promise--and perils--of putting faith in Wall Street

It's everywhere you look: splashed across television screens, newspapers, book jackets, Web sites. It's the hot topic around office watercoolers, at cocktail parties, gyms, bars, golf courses, beauty salons. It seduces taxi drivers and corporate executives, farmers and artists. For many people, it becomes an obsession, dominating their thoughts and dictating their actions. But despite the near-religious zeal of some of its followers, this is a decidedly secular phenomenon. It's the stock market.

Individuals across America are mesmerized by a market that has rocketed almost 60% in just 19 months. The stock market's promise of strong, steady growth exerts a powerful allure in these anxious times. As the market pushes ever higher, as job insecurity mounts, and as more companies give employees the opportunity--and the burden--of investing their retirement savings, people are relying on stocks as never before.

The nation's infatuation with equities holds enormous promise for individuals, companies, the economy, and the market itself. The flood of money pouring into equities has boosted the net worth of millions of Americans, linking them more closely to the fortunes of Corporate America. At the same time, it is leading to what amounts to a transfer of wealth from the corporation to the individual. Old-fashioned pension plans provided employees with a fixed benefit, regardless of market performance. If the market rose, companies would reap the big benefit--sharply lower costs for the pension plan. But now that many companies have shifted to 401(k) pension plans and their employees have piled into stocks, the big market gains are going to the little guys.

PILING IN. But companies are benefiting from the bull market as well. As demand by individuals pumps up stock prices, a corporation's cost of raising capital plummets. The bull market has increased access to capital, not only for established companies but also for smaller companies that are so crucial to economic growth and job creation. That capital lets companies take risks, innovate, and become stronger global competitors. Not least, it spurs economic growth.

But the new love affair with stocks also exposes millions of Americans to risks they've never before encountered. The risks could affect even more millions if proposals ever pan out to allow workers to direct part of their Social Security payroll taxes into stocks. "What we're seeing is the democratization of risk, and that has good and bad implications," says Roger M. Kubarych, general manager of investment firm Henry Kaufman & Co.

Many investors in the market today are buying in as the market hits record highs. "People are buying at or near the market top," warns Joel Unger, vice-president of New York's Stralem Investments, reflecting the conventional view on Wall Street. What's attracting them is 30%-plus returns of recent years and the hope that those gains will be repeated. Far more likely, however, is that the market will settle down to its historical average of about 10% a year, with the possibility of a couple of years of meager gains. Many individuals and their fund managers gained their investing experience during a period of disinflation that produced the bull market. If individuals have unrealistically high expectations, they could become discouraged and dump equity holdings during market downcycles. The consequences could be far-reaching--and devastating.

As more people move into equities, they are moving out of individual stocks (page 98) and into mutual funds. They leave the responsibility for picking specific stocks to fund managers, although they can still move in and out of the market by switching into cash or other assets. The result: an incredible concentration of power in a handful of mutual-fund companies. The top 10 funds control about half of the industry's $3 trillion in assets. Almost half of that $3 trillion is in equity mutual funds, up from about 24%, or $246 billion, in 1990. In the first three months of 1996, $71.3 billion of the $79.4 billion flowing into the mutual-fund industry went into equity funds.

So much power in the hands of mutual-fund managers could destabilize the stock market--even more so than it did in the 1987 crash. When interest rates on 30-year Treasuries zoomed past 10% back then, the first ones to run for the doors were the big institutional players.

How individuals will react to any big market crash or bear market is also a wild card. Individual investors may be lulled by a market that seems to be moving in only one direction. Many of them have never experienced a market correction of any magnitude. But as people see a more direct link between the overall market and their retirement dollars and are able to rejigger portfolios with a mere phone call or click of a mouse, how will they react to a significant and unexpected threat to the market? In a new BUSINESS WEEK/Harris Poll (page 100), 48% of those surveyed said they would maintain stock holdings if the market crashed, and 10% said they would add to holdings. But 20% said they would sell. Since people often underestimate how they would react to hypothetical events, the proportion of individuals selling into a crash could be higher. If individuals panic, it could deepen any decline, damage the retirement prospects of millions, and chill economic growth.

HOME TRUTH. Stakes in this game are high: Much of the money flowing into stocks comes from the retirement savings of baby boomers. "The country's net personal savings are all flowing into mutual funds, largely equity funds," says Albert M. Wojnilower, senior economic adviser at the Clipper Group. Indeed, personal savings in 1995's first quarter on an annual basis was $265 billion, while inflows into equity funds are running at an annualized rate of about $250 billion.

True, stock ownership remains highly concentrated in the upper-income levels, but the number of Americans with an equity stake rose to 51.3 million in 1992, according to the New York Stock Exchange. That's up from 42.9 million in 1989, 20 million in 1965, and 6 million in the early 1950s. A study by James M. Poterba of Massachusetts Institute of Technology and Andrew A. Samwick of Dartmouth College pegs the percentage of the adult population with some form of equities at 37.4% in 1992, up from 33.2% in 1983. The percentage has undoubtedly risen since then.

Equities are playing a greater role in the financial net worth of households. In 1995, Federal Reserve data shows that the value of household stockholdings outweighed the value of home equity for the first time in decades, rising to $5.5 trillion, compared with $4.2 trillion in home equity. According to David D. Hale, chief economist at Zurich Kemper Investments in Chicago, household ownership of equities and mutual funds amounts to more than 25% of all household financial assets, compared with 15.5% in 1985 and 13.5% in 1975. The BUSINESS WEEK/Harris Poll shows that stocks are displacing real estate as the asset class of choice. The number of people in the poll picking stocks as the best investment rose to 10%, up from 5% in 1989. The number choosing mutual funds tripled, to 24%. Only 25% chose real estate as the best investment now, down from 40% in 1989.

Whether they realize it or not, some individuals are financing their equity stakes by taking on more real estate debt. "I have a son paying off a mortgage," says Wojnilower. "At the same time, every month he puts money into a mutual fund," rather than using that money to pay off more of his mortgage debt. That fits in with the experience of Jane King, president of Fairfield Financial Advisors in Wellesley, Mass. "Now, people have a 30-year mortgage with lower payments and can contribute to a 401(k), rather than a 15-year mortgage which would have had higher monthly payments," she says. According to Wojnilower, "the increase in consumer credit, in a large sense, has to be financing the purchase of stocks."

Equity mutual funds are being fed by the rising flow of funds from defined-contribution savings plans such as 401(k)s. Steady inflows from the payroll deductions of defined-contribution plans are manna from heaven for equity funds. More than half of all the assets in equity funds are held in tax-deferred retirement savings plans such as 401(k)s, 403(b)s, variable annuities, or individual retirement accounts (IRAs). The dollar value of stocks in defined-contribution plans in mid-1995 was $547 billion out of a total of $1.2 trillion in plan assets. Avi Nachmany, director of research at mutual-fund research and consulting firm Strategic Insight, estimates that more than three-quarters of all the assets in equity funds--more than $1 trillion--is earmarked for retirement or for other long-term objectives. That translates into a strong and stable underpinning to the equity market.

Right now, the investment choices in many 401(k) plans are very limited. Most plans allow employees to divvy up money among four or five different mutual funds. But many companies are now expanding their investment choices. Some plans even allow employees to take their 401(k) money to a broker and invest in individual stocks. That could ramp up the level of risk. Nancy Correnty, a 28-year-old insurance agent from Westport, Conn., was recently told that she had to switch into such a 401(k) plan. Until October, 1995, her retirement savings had been split equally between a money-market fund and a mix of bond and equity mutual funds in her company's plan. Now, the $6,000 in her plan is with a broker and is divided between two computer-related companies, Insight Enterprises and S3 Inc. Her annual rate of return in her old plan was 8% to 9% a year. Her new plan is up about 22% in the past six months.

Correnty is typical of a younger generation that is willing to take more risks in order to get higher returns. But the stock market's new followers run the gamut in terms of age and income. Consider the clients of broker Timothy J. Finucan, who heads up the Webster City (Iowa) office of brokerage firm Edward D. Jones & Co. His clients are 60- to 65-year-old farmers--either retired or close to it. Until recently, many of them had never owned stocks. "Without a doubt, I'm seeing some of these people's money move into equities," Finucan says. "My clients no longer look at me like I'm from a different planet when I bring up a stock. They want to hear the story." He continues: "Individual investors no longer ignore well-run businesses. Now, they want to be part of them."

NO SLOUCHES. While equity funds are hot, there is some evidence that individual stocks are regaining their allure. Just look at the growth of National Association of Investors Corp. (NAIC) in Royal Oak, Mich. The nonprofit group espouses a philosophy of slow and steady investment in stocks. In 1989, the NAIC had 6,000 investment clubs as members. Today, the number is 22,456 and climbing, with new clubs forming at the rate of 1,000 a month.

The NAIC's members are no slouches when it comes to investing. Their most famous chapter, a group of 16 older women in Illinois that call themselves the Beardstown Ladies, racked up a 23% average annual return over the past 10 years. Of course, the Beardstown Ladies and other investors have benefited from a long bull market. Still, an annual survey that the NAIC has commissioned since 1960 showed about 45.5% of its members matching or beating the 37.5% total return on the Standard & Poor's 500-stock index in 1995. That compares with about 20% of growth-oriented equity fund managers.

Individual investors would do well to take heed of the NAIC's winning buy-and-hold philosophy. If individuals focus on the long term and diversify their stockholdings, then their experience with the stock market is likely to be rewarding, providing they don't expect too much.

If individuals try to jump in and out of the market, however, the only people they may enrich are their brokers. Even worse, they could get whipsawed and miss out on major stock-market moves. "A lot of us worry more about people engaging in market-timing than about some long-term financial disaster," says William F. Sharpe, the Stanford University economist and Nobel prize winner. Mutual-fund managers share Sharpe's concern about market timing. Statistics from the Investment Company Institute, the mutual-fund trade group, show opportunistic and market-timing activity in equity funds declining in the past decade.

The resolve of many of today's stock-market investors has not been tested by a serious market decline. And this is a generation that could be far more sensitive to the ups and downs of the market. "Now, people see a direct correlation between stock-market fluctuations and their pension funds," says Elizabeth J. Mackay, market strategist at Bear, Stearns & Co. So far, individuals have responded to any market dips by buying. "It's been the right thing to buy the dips, or at least not sell," says Mackay. While many people fear that individuals will flee the market because of a sharp downdraft, Mackay thinks "the big risk is that we'll have an old-fashioned bear market where holdings slowly erode" and that after a few quarters of watching their holdings erode in value investors will head for the exits.

To be sure, a recent study by the Investment Company Institute shows that over a 50-year period, equity-fund investors have never bailed out of the market in large enough numbers to slam the market. And an analysis of bear markets since the 1960s by Strategic Insight's Nachmany found that "during times of financial uncertainty, investors...reduce the turnover of their financial assets and actually decrease redemption activity into a bear market." But as the market plays a bigger role in many individuals' financial destinies, and as information about the market and companies becomes more widely available, the historical trend of the individual holding on through thick and thin may not play out.

Even if individuals hunker down for the long haul, their mutual fund managers may not. If there is a big shock to the nation's financial system--like a sudden upsurge in inflation--the decision of whether to sell or stay in the market is in the hands of fund managers, not the individual. Mutual-fund managers, compared with individuals, are a far more demanding and impatient bunch.

WORRIED REGULATORS. As individuals pour their money into equity funds, larger chunks of a company's stock are controlled by intermediaries that are judged, in the main, on the basis of short-term performance. "For corporations, this shift means that there are a lot of holders out there who can abandon you at the drop of a hat," says Professor Louis Lowenstein of Columbia University law school. "Individuals aren't performance-oriented the way institutions are, and they certainly aren't focusing on returns from quarter-to-quarter."

When there is trouble with an individual company, Wojnilower argues that fund managers are more likely to move out of a stock than agitate for change. Hale of Zurich Kemper Investments agrees: "You can do what CalPERS [California Public Employees Retirement System] does and lobby a company, or you can sell. On the whole, mutual-fund management companies don't have a lot of time for politics."

The rush into stocks weighs heavily on the minds of regulators. In a speech on May 22, Securities & Exchange Commission Chairman Arthur Levitt Jr. noted that "there is a wide gap between [individuals'] financial knowledge and their financial responsibility" to invest their retirement savings.

Lowenstein puts it in a broader context: "When all of the industry, the economy of the country, is linked to the stock market the way it is now and never has been before, you've got to be concerned," he says. "In a concrete way, that makes regulators worry about the stability of the market and to try to avoid market panics. They begin to feel a public responsibility to protect the market."

That sense of responsibility may have sparked the SEC's response to a news story concerning America's largest mutual- fund company, Fidelity Investments. The fact that Fidelity has 10 million shareholders and $277 billion in its equity funds helps explain why the SEC stunned the financial world by abandoning its usual "no comment" response when a story alleging improprieties among Fidelity fund managers surfaced in the press. At the time, there were concerns among market traders that some individuals would start to dump their Fidelity holdings. The SEC put out a statement saying that the article "contains inaccuracies which have led to erroneous impressions." Fidelity is bigger than the biggest bank. So, "if that story is untrue, then the government does have an interest," says Burton G. Malkiel, an economist at Princeton University and author of the influential book, A Random Walk Down Wall Street. Malkiel likens it to how the Federal Reserve would be worried about a run on a bank.

PREMIUM ON GROWTH. For all the perils it presents, the new link between Main Street and Wall Street may bring rewards that outweigh the risks. "Ultimately, corporations may take on more risky things because individuals collectively have more appetite for risk," says Sharpe, and that could lead to an increased growth rate in the economy. "One hopes that a society can take more risk and make a greater return in a long run because we're better at sharing the risk."

For a glimpse of just how much risk investors are willing to shoulder, and how companies benefit, take a look at the flood of initial public offerings (IPOs). As of May 17, investors had coughed up a record $19 billion in 1996 to get in on the ground floor of what could be the next Netscape Communications Corp.

That amount is almost double the IPO issuance for the same period a year ago. Since 1980, most of America's employment has been concentrated in small and midsize companies. Since many of these startups are in the technology field, providing them with the low-cost capital they need helps ensure American technological leadership.

More concentration in the hands of mutual-fund managers puts more pressure on companies to deliver growth. That affects a company's market value, as its stock price becomes more aligned with its growth prospects, says James Burke, director of research at New York consultants CDA Equity Intelligence. He says that dividends are becoming irrelevant because institutions are focused on what produces the returns that they need to keep mutual-fund managers happy: growth.

If individuals' portfolios benefit from that focus on growth, the economy could benefit in another way. An idea that economists call "the wealth effect" says that when asset values rise, people spend more money. Hale thinks the economy is strong now "because in 1995 we had big household wealth gains."

Granted, a boost in household wealth because of a rip-roaring stock market is generally thought to have only a small impact on consumer spending--perhaps 2% to 3% of the total wealth gain. On 1995's $1 trillion-plus gain from equities, that translates into $20 to $30 billion. But some market veterans think that today's bull market will lead to a more pronounced wealth effect than the nation has seen in a number of generations. After such a prolonged bull market, "a lot of people feel wealthier," says Robert J. Farrell, senior investment adviser at Merrill Lynch & Co. That helps explain why consumer spending has not disappeared during a time when wage increases are small and the number of credit-card defaults and personal bankruptcies is high.

At first blush, it looks as if the wealth effect would increase spending and reduce savings. But that's not the case. Increased consumer spending generates a higher level of income through the economy, which then leads to higher total savings in the economy. Savings could also benefit from the growth of tax-deferred savings plans such as 401(k)s. In defined-benefit plans, companies would often react to a rising stock market by scaling back their contributions to the plan and letting market appreciation fill the gap. In defined-contribution plans, however, individuals don't reduce contributions in the face of rising prices. On the contrary, they increase them.

The embrace of equities by individuals has surely introduced a new level of risk into the market and the economy. It has also become an engine of wealth creation for many more Americans. It has encouraged individuals to take more responsibility for their financial future. And despite the warnings of the naysayers, it may well be the beginning of a long-lasting love affair.By Suzanne Woolley in New YorkReturn to top

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