The Great Stock Market Myth

Original article was published by Paul Signorelli on Artificial Intelligence on Medium

The Great Stock Market Myth

One of the biggest contributors to the wealth gap is the uneven playing field of the stock market, but with the help of technology, I think we can level it

Photo by Austin Distel on Unsplash

“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

— Warren Buffet

Wall street wants main street to believe that the stock market offers a path for anyone to build wealth. Invest in the companies that drive the American economy and you will be rewarded. For a small group of investors who have an inside advantage the stock market generates enormous wealth. But for the retail investor, it is a total failure. The retail investor is the patsy in Warren Buffet’s famous quote. Call it what you want, value investing, dollar cost averaging, buy and hold, but the strategies available to the average retail investor compared to those at the disposal of the wealthy are disproportionate in their ability to generate return. I believe this imbalance is a primary contributor to the wealth gap that exists in America today.

Return on Investment

Imagine a married couple starting to invest for retirement in 1980. Suppose they are both at the age of 25, and are making the median house hold income (in 2020 dollars) of $81,000. With the hopes of retiring at 65 they dutifully invest 5% of their gross income each year for 40 years.

Year over year portfolio value based upon annual S&P 500 return assuming an annual 5% investment of inflation adjusted yearly house hold median income

Based upon the historical return of the S&P when they reach 65 they would have a portfolio that is worth over $3,000,000. At first glance, this seems like a very nice retirement nest egg that will allow our imaginary couple to retire to a good life and even pass something on to their children. However, the value of a dollar in 2020 is not what it was in 1980.

Inflation adjusted portfolio value based upon annual S&P 500 return assuming an annual 5% investment of inflation adjusted yearly house hold median income

Their inflation adjusted return is only about $730,000. This is still a generous sum, but it nets them less than 10 years of retirement salary at their 1980 median salary rate. Hardly enough savings for a robust retirement after a life time of hard work and saving diligently.

Furthermore, this amount on its own could not generate enough low risk income with interest rates and bond yields so low. When they started this journey 40 years ago, they could likely have lived off the earnings the money generated in a CD. Now their $3,000,000 sum would only net them about $20,000 per year in a 10-year treasury.

They may be forced to leave that money deployed in the market where they can get higher returns at higher risk with a much shorter time horizon to make up any loses that occur when the market goes down. A situation many people found themselves in during the fall of 2008, when the financial system imploded and the S&P lost over 56% of its value.

In fact, a person who retired in the year 2000 would have seen their portfolio lose more than half of its value in the following nine years. It would have taken until this year for the portfolio to recover to the level it was at when they retired, in inflation adjusted terms. Twenty lost years, and that is before the COVID-19 market meltdown took another chunk out of it.

Of course, all of this presumes that our imaginary couple could afford to put away 5% of their gross salary. This would not be easy if they had kids, a mortgage, a car, and all the other expenses that come with life. Maybe they were lucky and they had a 401k with a company match. They could achieve their 5% goal with a partial investment from their employer. However, even though employer matches have ranged in the 3% to 5% range historically, this data only counts companies that offer a 401k. This does not count the growing number of companies who do not offer them at all. Research has shown as many as 35% of all workers have no access to a 401k.

Investor Class Ceiling

Photo by Nick Fewings on Unsplash

Maybe this is why 45% of Americans are not invested in the stock market, and participation is falling, not rising. Many people simply cannot afford the capital and the risk. Furthermore, they are shut out of the types of investment vehicles and tools (IPO’s, hedge funds, derivatives, leverage, etc.) that generate the kind of alpha needed to create and maintain generational wealth. In fact, less than one-third of Americans in the lower income brackets own stock, while over 94% of individuals in the highest tax bracket do.

Wealthy investors have or can raise cash when the market has a major correction. Market crashes are opportunities to increase their wealth exponentially. For the retail investor, they are major setbacks that some never recover from.

To make matters more alarming. This participation trend is in stark contrast to other parts of our society. About 91% of American households own a car. More than 70% of the world population has a smart phone. Over 4 billion people had flown on a plane as of 2015. Things that were once considered luxury items are now used by the masses.

The political and investor class looks at these statistics and holds them up as proof we live in a society that provides equal economic opportunity for all. But as far as the stock market goes — the lower classes are woefully underrepresented. It appears that investing is immune to Moore’s law. Is it any wonder that politicians such as Bernie Sanders and Alexandra Ocasio-Cortez have a message that resonates with so many, particularly the young, who can plainly see the inequity in this situation?

Equal Opportunity

To be clear, I am not a fan of the Sanders/AOC solution of taxing our way out of this problem. However, they have their finger on the pulse of the issue. The inequity in the markets is not just about unequal outcomes which are part of life. This is about an inequity of opportunity.

Wealthy investors, by nature of their accredited status, are afforded better opportunities. A wealthy investor can access hedge funds where lower income investors are legally blocked from doing so. According to our benevolent leaders that it is for their own protection. The stock market is too risky for them. Wealthy people have more wisdom and capacity to manage the risk according to the government. Maybe this is true, but it also sets up the convenient scenario where the retail investor gets to play the patsy in Warren Buffet’s card game. If everyone was in on it, then nobody would win.

I have met a lot of wealthy people in my life. Most of them were smart, hard working, individuals, who took risks, made sacrifices and earned their wealth, helping countless others along the way. But just because someone, by nature of their hard work, risk, and intelligence became wealthy, does not make them more qualified to invest their money in the stock market. Nor should it afford them some special opportunity to participate in the markets in a way that a school teacher, fireman, or taxi-driver cannot.

They may have more capital to put to work and as a result they may earn more absolute dollars. But why should their wealth status give them opportunities others do not have?

The Solution is Always the Same

The good news is there is a solution. It is the same solution that always rescues us — technology.

Besides regulations, there are a few things that prevent smaller investors from participating in things like hedge funds. First, is cost. For Hedge Funds to raise the kind of capital needed to run a successful fund takes capital from investors. Raising that from a handful of wealthy investors will cost less than having to raise the money from hundreds or thousands of smaller investors. It is also easier to manage a smaller pool of investors than a large one.

That is why retail investors are forced into things like Mutual Funds and ETF’s where they are a faceless share holder inside an investing strategy that historically performs no better than the market indices.

The other big issue is supply of expertise. The people who create successful investment strategies are in rare supply. These individuals have enormous intelligence and market expertise and are highly sought after. There are not enough of them to support the number of retail investors that must be supported in higher alpha investing strategies.

But like in so many other areas of life, technology can bridge this gap. Artificial Intelligence and Machine Learning algorithms that can automatically generate high-alpha market strategies, micro-investing platforms that can lower the capital needed to purchase equities, and block-chain technologies that automate secure transactions are all examples of technologies that are starting to revolutionize investing.

By using technology to lower the cost to deliver high-alpha investing it is now more than possible to bring these services to all investors, level the playing field, and close the opportunity gap that holds back so many people.