What have we learned?

Posted by on January 7, 2010 @ 9:52 am in Investing

Like everyone else, I’ve been reading (well, skimming) reams of year-end—and in some places, “decade-end”—economic summaries. There’s lots of talk about black swans, financial “Frankensteins,” lost decades, and fundamental changes in investor behavior.

Black swans are old news, and I’ve written on financial innovation and lost decades previously. And I’ve only got a tiny bit to say about investor behavior. I’ll get to that after sharing a few other observations I wish got more attention in all this year-in-reviewing.

1. Faith and patience

It strikes me that way too many people were surprised by the fact that financial markets and the modern economy are very much built on faith and patience, and that loss of either (or both!) leads to chaos. Almost everything you need to know about the fundamental fragility of a modern economy can be learned by watching the bank-run scene in “It’s a Wonderful Life” or by reading a snippet of Keynes:

“Of the maxims of orthodox finance, none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.”

Perhaps the biggest financial challenge we will continue to face is how to deal with ever-increasing flexibility and instantaneousness in the financial system while there remain tremendous inflexibilities in the actual economy.

2. A triumph of policymaking

The success of central banks in halting a worldwide financial panic that was clearly and dangerously feeding upon itself was remarkable, and I think it’s what will be remembered longest about the most recent crisis. The key remaining question is how quickly the monetary authorities will be able to react when the private banking system starts creating money again in a significant way.

If the Fed and other central banks pull off this balancing act (and I believe they can), the events of the last few years are likely to be remembered years from now as a triumph, rather than as a failure, of economic/financial policymaking. Nothing policymakers can do is ever going to vanquish greed, arrogance, fear, fraud, or speculative bubbles and crashes. Knowing that we have effective policy tools to help get through very serious instances of such crashes without suffering Depression-like consequences would mean vast improvement in all our lives (though obviously there will still be plenty of pain).

3. Investor consistency

Things change glacially, even in the face of what seem like “watershed” events. For example, there has been some discussion of whether individual investors will “return to the stock market.” Research that Steve Utkus and I have done surveying investors earlier this year suggests that most investors never left.

And in terms of a dramatic shift in investing patterns, I’ll refer to the data in the chart below, which show net new cash flows to stock mutual funds plotted alongside total returns for the S&P 500 Index, both on a rolling, most-recent-twelve-months basis.

The S&P 500 Index and net new cash flows to equity mutual funds

December 1984-November 2009
The S&P 500 Index and net new cash flows to equity mutual funds

Notes: Vanguard calculations based on mutual fund flow and historical total net asset data from the Investment Company Institute (as of 12/31/2009). S&P 500 total return is as recorded by Vanguard. Net new cash for equity mutual funds is the sum of net new cash flow to equity funds over the trailing 12 months divided by the average of total net assets at the end of each of those months.

I look at this and see no break in the pattern through November of this year. These two series are very much related, especially after about 1994, and while the recent market collapse was huge, recent flows appear to be in line with the observed relationship. If the markets turn in continued good performance, my guess would be the cash is likely to follow.

4. A note of thanks

Finally, at the end of what most are calling, if nothing else, a disappointing decade, it seems to me that a little thankfulness and humility are in order. Things could have turned out very differently.

My grandparents suffered through a ten-year period that included a total economic and political collapse, chaos, war, and personal hardship and tragedy that I can’t pretend to imagine, and somehow survived. I count my family incredibly lucky to come out of this decade in basically good shape, and myself fortunate to be able to do work that I love with friends and colleagues that I respect, for a sound enterprise that we all strongly believe in and to which we’re devoted. So, rather than disdainfully looking back, I’ll look forward to face the new year and the upcoming “teens” with great hope—and only a little trepidation.

Happy New Year!

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