Is There a Retirement Savings Bubble Forming From Long-Term Investments?

A reader writes in:

Hi Trent, have you seen this article from Planet Money? This article makes a good case that a bubble is forming in the stock market based on the reduced influence of individual investors. The question is, where do you put the money if you’re already diversified with real estate, bonds and have a sizable emergency fund? I don’t know if set it and forget it index investing will be a smart move over then next decades…

Is Your Retirement Fund Ruining Our Economy? @ NPR Planet Money

So, let’s break down what the article is saying into some bite-sized pieces we can work with.

The article’s main point is that people who are putting money into their retirement savings are having weird effects on the overall economy.

In the past, investors would move money around from investment to investment based on how that particular type of investment was doing. So, if you had shares of Coca-Cola and it looked like Coca-Cola might be struggling and you instead felt good about, say, real estate in the outer suburbs in your city, you would sell your Coca-Cola stocks and use it to buy some land from a farmer out around the city edges. Maybe a person put all of their money into a municipal bond issued by the city they live in to build better sewers, but they decided that it wasn’t returning as much as they wanted, so they sell it so that they can buy shares in Google because they believe it has a big future. You get the idea — people are buying and selling based on information. Good information makes the price of an investment go up, and bad information makes it go down.

Nowadays, many individual people are saving for their own retirement. They’re not being promised pensions anymore, so they use 401(k) and similar plans to save for retirement. Within those plans, they have a lot of investment options and, because most people aren’t active investors, they find what seems to be a good investment and park their money in it. Often, that investment is a broad-based index fund, which means that they’re essentially buying tiny amounts of tons of different companies.

Here’s the thing: people put their money in there and then just let it sit for years and years and years and years. They never move it out until they actually need it in retirement.

If enough people do this, investments start to change in nature. If a lot of people who own Coca-Cola stocks are just going to sit on them for decades regardless of news, weird things start to happen.

For starters, the price is slowly but constantly being driven upwards by the fact that more and more and more shares are being bought and held, which means that there are fewer and fewer and fewer shares of that company actually available. As with any kind of supply and demand, if there are fewer shares available, the price is going to go up.

That’s good for the time being, but eventually people will retire and will start selling those shares off. At that point, there will be a steady increase in supply, so the value of those shares is going to go down.

The strange part is that none of this has to do with the actual health and performance of the company. A person buying into an index fund is basically buying a share of Coca-Cola — regardless of how Coca-Cola Company is doing at the moment — sitting on it for a long time, then selling off that share of Coca-Cola, regardless of how the Coca-Cola Company is doing at that moment, and it’s doing this with all of the shares in the stock market at once.

To be specific, from the article:

Legal scholars Lucian A. Bebchuk and Scott Hirst recently published a working paper called “The Specter of the Giant Three.” The vast majority of money flowing into index funds are run by three companies: Vanguard, BlackRock, and State Street Global Advisors. Their combined average stake in each of the top 500 American corporations (the S&P 500) has gone from 5.2% in 1998 to 20.5% in 2017.

So, right now, people putting money aside for retirement into “buy and hold” index funds collectively own more than 20% of the shares of the top 500 American corporations. The article expects this to continue to grow for a while.

So, here’s the big question: is that a bad thing?

The article looks at a few different reasons why it’s bad, but the reason that really matters to individual investors is that this might be a bubble. At some point, people will start selling all of the stocks that they’ve bought and held. That likely has more to do with people growing old naturally than anything in the economy, but it will eventually happen. What happens then? Since this will be a gradual shift, what you’ll probably see, rather than a crash, is a gradual slowdown in stock market growth. Everybody won’t start selling at once, so rather than “popping” like a lot of investment bubbles, what you’ll see is a gradual slowing.

What does that mean for people with a 401(k) with a lot of money in index funds? It means that, right now, they’re seeing growth in their stocks that’s bigger than one might expect based on the health of the economy. However, in the future, when lots of people start selling off their 401(k) money in retirement, the growth in stocks will be slower than one might expect based on the health of the economy.

I think this entire idea makes a lot of sense, so the question then becomes what can we do about it?

The solution, as always, is diversification. Don’t have everything you own in one type of investment, particularly if you will need that money soon. The article offers at least one clear suggestion for alternative places to put your money – the stocks of smaller companies that aren’t included as heavily in index funds. You might also want to put money into international stocks, real estate, bonds or other things.

How do you do that easily, though? The easy way to do it is to just use a target retirement fund in your retirement plan. Most target retirement funds diversify quite a bit and don’t just put everything into the stocks of big American companies. They’ll often have some bonds, some real estate, some small company stock, some cash, and some international stocks. This is particularly true as people get closer to that target retirement date.

So, go into your retirement account and take a long look at the target retirement funds they have on offer. Are they very heavily invested in stocks, especially those of big companies? You might want to consider putting part of your contributions into something else. However, if they’re like most target retirement funds and are diversified a little with stuff besides big American companies, that’s another reason to put your money in there.

In the end, no one knows for sure how all of this will turn out. No matter how you choose to invest, you’re taking a risk, and the reason index funds are so successful is because they spread out the risk, but in being successful at that, they may have created another kind of risk.

Just remember that your contributions trump everything else. By simply increasing the amount you’re saving for retirement, you render much of this a moot point.

My advice? Save as much as you can for retirement and put it in a target retirement fund. Make sure that the retirement fund is invested in more than just big American companies — look for things like small companies, international companies, real estate and bonds. The best thing you can do to spread out your risk is to diversify.

Good luck!

Trent Hamm

Founder & Columnist

Trent Hamm founded The Simple Dollar in 2006 and still writes a daily column on personal finance. He’s the author of three books published by Simon & Schuster and Financial Times Press, has contributed to Business Insider, US News & World Report, Yahoo Finance, and Lifehacker, and his financial advice has been featured in The New York Times, TIME, Forbes, The Guardian, and elsewhere.