MONEY FOR NOTHING?

SYNOPSIS: An entire nation of investors is not going to be able to beat the market.

Economists don't usually make good speculators, because they think too much. Like the famous if apocryphal professor who refused to pick up a $100 bill, they tend to assume that if there were money to be had, someone would already have taken it.

However, caution that can be a liability on the trading floor is an asset off it. Sometimes the observant do spot opportunities for large, risk-free gain -- $100 bills lying in the street -- that others have somehow missed. But a wise man doesn't assume that such opportunities will present themselves on a regular basis, and he certainly doesn't use that assumption as a basis for his family budget -- or his plan to save Social Security.

It is a fact that historically stocks have been a very good investment. The best-known demonstration of that fact comes from Jeremy Siegel of the University of Pennsylvania, who has pointed out --in his book "Stocks for the Long Run" -- that during the 20th century anyone who was willing to buy and hold for long periods would almost always have done better buying stocks than bonds. So there wasn't a tradeoff between risk and return: stocks were just a better investment, period. It turns out that there was a $100 bill lying on the sidewalk (quite a few billion bills, actually) that for some reason nobody picked up.

But many people have misunderstood what that observation means. It doesn't say that there is some natural law guaranteeing that stocks will always be a great investment; it says that historically stocks have been underpriced. Investors weren't willing to pay as much for claims on corporate earnings as they would have if they had properly understood how low the risks were.

And a funny thing happened on the way to the 21st century: the price-earnings ratio -- the price of a dollar of corporate earnings -- soared. In the period studied by Professor Siegel prices were on average less than 15 times earnings, and stock investors on average earned a real return of 7 percent. Nowadays the price-earnings ratio is on average more like 30. Is this irrational exuberance, or did investors finally absorb Professor Siegel's lesson? Either way, that $100 bill has now been picked up. If stock investors now have to pay twice as much as they used to for a claim on earnings, and if profits grow in the future as they have in the past, those investors should now expect to earn only half the historical rate of return.

And yet many of those offering plans to reform Social Security -- among them, of course, advisers to George W. Bush -- insist that stocks are the answer, and that it is safe to assume that stocks will keep on yielding 7 percent forever. And if you try to point out that buying a piece of corporate America is much more expensive than it used to be, they just repeat the mantra that stocks have historically been a great investment. In other words, that $100 bill was there yesterday, so it must still be there, right?

Is the odd susceptibility of first-rate economists to such a na´ve fallacy a triumph of wishful thinking over analysis, or a disingenuous bow to political expediency? Recent remarks by Mr. Bush offer evidence of good old-fashioned American disingenuity at work.

In a May 15 speech he asked his listeners to "consider this simple fact: even if a worker chose only the safest investment in the world, an inflation-adjusted U.S. government bond, he or she would receive twice the rate of return of Social Security." That's an amazing fact; it's even more amazing when you realize that the Social Security system invests all its money in, you guessed it, U.S. government bonds. But the explanation -- which Mr. Bush's advisers understand very well, even if the governor does not -- is that today's workers are not only paying for their own retirement, but also supporting today's retirees. And if you think that's a minor detail -- that the question of how to meet existing obligations when workers are allowed to invest their contributions elsewhere is a side issue -- let me assure you that I too would have no trouble devising a painless plan to save Social Security, if you let me assume that a large part of the system's obligations would magically disappear.

Or maybe "magic" isn't quite the right word. How about "voodoo"?

Originally published in The New York Times, 5.28.00