Monday, March 23, 2009

Wellington's Waterloo

An article on the beaten, bruised, and battered 401(k) accounts that have taken a major hit from the economic crash provides an interesting example of reality vs. illusion in the world of finance. According to a 28-year (plus 2 months of 2009) chart of returns from the Vanguard Wellington fund, $5000 invested at the beginning of each year since 1981 would have yielded a year-end value for 2007 of approx. $928,000. That's with annual returns ranging up to a breathtaking 33% (in 1995), and only three years of negative annual returns through 2007. Call that $928,000 the baseline for the disillusionment which was to follow, because in 2008 the year-end value was approx. $725,000, a drop of over $200,000. So the hapless account holder, as far as he or she is concerned, "lost" $200,000, or 22%, in one year. But wait, there's more! In the first two months of 2009, the value would have gone down another 11%. That's 11% in two months, or 66% by the end of 2009, if things go the way they've been going. (But it might be worse!) And the net loss from the end of 2007 to the end of February 2009 is 30%.

Sounds horrible, right? But consider -- that end-of-2007 figure, if based on a fixed interest rate, would have represented a yield of between 21% and 22% over the period in question -- not at all shabby. But what about all the "losses"? Well, the end-of-2008 figure _still_ represents a yield between 19% and 20%... and the end-of-Feburary 2009 figure represents a yield between 18% and 19%. So after the crushing losses of the last few months, our 401(k) holder with this fund has still realized a yield of between 18% and 19% overall -- which beats the crap out of any bank, T-bill, bond, or even gold, I believe. So do these people have any right to complain? Isn't it just possible that their sky-high yields of years past were nothing but a "bubble", that didn't represent anything of real value? Isn't it possible that the current value of their account is more realistic, i.e. it might just be what they should have been making all along. Or, to put it another way, if they had seen straight-line growth from 1981 to now, with a yield of 18-19%, they'd be on cloud nine... BUT since they thought, back at the end of 2007, that they were even richer, now they're miserable... depressed... suicidal. "It's all relative", as someone once said.

But let's look at it still another way. Let's say the person in question started the account in 1981 and never withdrew a dime. The account's value, based on the rate of return, is a "value on paper", which is, in turn, a tiny portion of the _total_ "value on paper" of all of the assets of the fund... and that, in turn, is based on selling prices, not of _their_ holdings, which they usually aren't turning over, but of similar holdings which _are_ being turned over, i.e. sold. In other words, if, say, 1% of the total stock of a firm is sold on a given day, the price of that stock is attributed to the other 99% of the stock, as its "value". But the fact is, if that other 99% went on the market the same day (or week, or month) there's no way the sellers could have gotten that price for it... or any price at all, for that matter. Which is to say, the laws of supply and demand apply automatically to stocks that are being bought and sold on the free market -- but it's a mistake to apply them to stocks that _aren't_ being bought or sold. And while it's true that most of the classic "bubbles" are based on fast buying and selling of the commodity in question, there is another kind of bubble as well, and that has to do with stocks that are just sitting there in someone's portfolio, but which seem to be appreciating in value at a rapid rate based on what's happening to other stocks. So what I suspect about most of these 401(k) funds is that they were relatively stable with regard to the makeup of the portfolios in question -- in other words, a very small percentage of the holdings were actually being bought or sold on any given day. Which means, most of the appreciation in value was _not_ based directly on sales, but only on _attributed_ value, i.e. on the market value of the similar stocks that were being sold by other people. Which means -- in turn -- (finally, a bottom line!) -- that these 401(k) portfolios were _never_ worth as much as people thought they were... i.e. if they had gone on the market the price would have turned out to be much lower, especially if large chunks had gone on the market all at once.

So what does this mean in terms of the alleged $2 trillion in 401(k) losses in 17 months? Were those accounts, in the aggregate, _ever_ worth that much? Or was a lot of that "value" just notional and on paper, and not based on any sort of realistic scenario? If I own some stock and decide to sell it, the fact of my selling it is probably not going to have a major impact on the price, unless I'm some kind of high roller. But if a major 401(k) fund decides to sell, it could very easily have an impact on the price... and this is my point. The bigger the aggregate, the less accurate the assignment of "value" is, to the point where, if a given fund, or a given stock within a fund, is, for all intents and purposes, impossible to liquidate on short notice, or all at once, without suffering huge losses, then the value assigned to it is basically meaningless. Which means that all of these people who think they "lost" a lot may not have -- not really. What they "lost" was value on paper, but not real value, and certainly not anything tangible. Of course, that won't stop the boo-hooing and the rending of garments, and it won't stop politicians from making the most of a bad situation. But it might be some small consolation to a person who wound up holding the short straw that a lot of what they "lost" never actually existed.

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