The Road Ahead
by Pat Regnier

March 9, 2007

[Continued, page 2]

Q: I've read that we're a demographic time bomb. Will we crash the market just when I retire?

A: From an economic perspective, boomers have three key traits: There are a lot of you. You didn't choose to have big families. And you are going to live a mighty long time. What all that adds up to is that by 2030 there will be barely three Americans of working age for every person over 65, compared with a ratio of five to one today. That's going to be a significant challenge to Social Security. It might also be a problem for stocks. To finance their retirement, folks over 65 will have to sell assets, but there will be relatively fewer young Americans to buy them.

This shift could certainly be another long-term drag on your returns. Economist James Poterba of the Massachusetts Institute of Technology guesses that it might cost investors an average of a quarter to half a percentage point per year. But don't waste your time listening to any market guru who promises that demographic trend lines can tell you when to hop out of stocks to miss the boomer-driven crash. There may never be one, Poterba says. The so-called age wave is a widely known and easily tracked statistical event, and the market has a way of calculating information into prices long before any zero hour arrives.

Several forces could blunt the impact of boomer aging. Siegel, for example, has argued that a rising middle class in India and China will seek the safety of U.S. equities. And boomers surely aren't going to try to sell all at once. Some will hardly sell at all. A big chunk of this country's assets are in the hands of the richest investors. "Most wealthy people save a high percentage of income," says Roger Ibbotson, founder of Ibbotson Associates and professor at Yale School of Management. "They aren't really digging into their savings when they retire."

Q: I made 20% in a foreign fund last year. Can't I juice up my returns by going overseas?

A: Because other countries' markets don't always move in sync with ours, holding a stake in a foreign fund can smooth out your performance and maybe even kick up your returns. Over the past five years, in fact, foreign stock funds have averaged a 15% annual gain, compared with just 7% for U.S. large-cap funds, a record that has drawn a flood of new investors. But you shouldn't expect that kind of extreme outperformance to continue. In a globalized world, a multinational company based in Paris doesn't really face different economic realities from a competitor in Chicago. And Europeans and the Japanese are facing an even bigger demographic crunch than we are—they're not having enough babies to replace their current population.

Emerging markets—that is, less developed economies including China, Latin America and Russia—seem to offer potential for bigger gains. But that's because they are also a bigger risk. On average, diversified emerging markets funds rose a stunning 25% annualized over the past five years, but they also lost half of their value during one bad 12-month run in the late 1990s. And the long-term record of emerging markets isn't as impressive as you might think, says Yale finance professor Will Goetzmann, a leading expert on past market returns. "Despite their risk, emerging markets historically really haven't done that dramatically better over the long term," he says. And although the fall of the Berlin Wall and the economic emergence of China would seem to herald a new era of opportunity, Goetzmann cautions that some markets can disappear as quickly as they "emerged." Most investors should keep their emerging markets bet small, perhaps by simply buying a diversified foreign fund that dabbles in those countries. More adventurous types might think about putting 5% of assets in a dedicated emerging markets fund.

Q: What about commodities? I hear they're the next big thing.

A: Wall Street's been pushing them pretty hard lately. It seems like every week a new mutual fund or ETF is launched to track one commodity or another. But before you climb into the trading pit, remember that your odds of consistently outsmarting the market's bet on the value of a bushel of wheat or a barrel of oil aren't any better than your chance of guessing what's next for Google. The best case for buying commodities is for diversification. New research shows that a broad index of commodities futures can offer solid long-term returns, while in the short-term they can often rise as stocks fall (and vice versa, of course), lowering your overall volatility. If that's attractive to you, you can buy an exchange-traded investment like iPath Dow Jones-AIG Commodity Index Total Return (ticker symbol: DJP), a MONEY 70 pick that tracks the return of a commodity index at a low cost.

Still, these new and complex investments are strictly for the advanced investor. Even then, it's possible that commodity returns will erode now that the big money on Wall Street has piled in. "People become enamored of assets that are good diversifiers only after they've had higher than normal returns, which is when returns going forward are low," argues William Bernstein, author of The Intelligent Asset Allocator. The bottom line is that commodities might be useful as a small part of your portfolio (think single digits), but they won't be a money machine that transforms your lifestyle.

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