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A Time Out for Q&A
While the Markets Are Quiet, Time for Expanded Responses
 By Ernie Ankrim, Chief Investment Strategist
Russell Investment Group
Global Leaders in Multi-Manager Investing
March 3, 2005
This article has been provided by our parent company, and any references to rates or returns are based in $US and specifically relate to US markets.
The beginning of 2005 has been a flat period overall for equity markets. We've seen ups, we've seen downs, and in sum we've essentially seen a return to where the market began on January 1st. So in the absence of significant news, I thought I'd take the chance to offer extended responses to two questions I've received in the past month.
Q1: "The definitive widows-and-orphans stock, AT&T, is heading into history. Are there stocks likely to replace it?"
Jeff Opdyke of The Wall Street Journal posed this question and my answer (in short form) was quoted as follows (in his February 3, Personal Journal section article):
"The very notion of a widows-and-orphans stock came out of the 1930s and 40s — a stock that wasn't going to set the world on fire, but which you knew would be there for you 30 years later when you needed it. There is no reason a widow or orphan today should be subject to the risk of a single stock."
It's true that once upon a time, the mighty "T" symbol on the New York Stock Exchange — AT&T — was the most widely-held stock in the world. And as such, it was the bellwether buy-and-hold stock; viewed as an ideal long-term purchase for neophyte or hands-off investors.
Even though the AT&T brand name will still be an important asset of its original offspring SBC, that doesn't necessarily make SBC, or any single issue for that matter, a bulletproof holding. The idea of widows-and-orphans stocks dates back over half a century, and the investing world has significantly changed since then.
We've become much smarter about risk — what it is, and how to lessen its effects. The Nobel Prize winning works of Harry Markowitz and Bill Sharpe showed investors that portfolio risk can be broken down into two parts. First, there's systematic risk, representing the risk of the equity market in general. But second, there's also idiosyncratic (or unsystematic) risk, representing the unique circumstances that can affect the price of a single stock — factors that make its price shoot into the stratosphere, head south, or do both in succession as illustrated in recent cases of once high-flying tech issues or firms whose fortunes have been dashed by management fraud.
Professors Markowitz and Sharpe showed that idiosyncratic risk was bad not only for it's added volatility, but because investors were not, on average, compensated for taking it. This analysis made evident the wisdom of holding a wide variety of stocks.
Diversification is how we reduce idiosyncratic risk, because while the price of one or two stocks may plunge as their chief executives are hauled before committees, it's unlikely that every listed issue will sharply drop in value. Yet, it used to be difficult for the average widow or orphan to assemble a well-diversified stock portfolio.
The emergence of mutual funds changed all that: it's only been in recent decades that funds have been widely available that encompass all styles, sectors and countries. If we're still going to use the term widows-and-orphans as an idiom for conservative investing, I think it should now be paired with "broadly based mutual fund" instead of "stock" — because single-issue investing is as behind the times as rotary phones.
Q2: "What do you think of US President Bush's proposed reforms to Social Security? What are the implications for investors?"
This is a touchy and important question that has been posed at every client presentation I've made this year (11 and counting). To start I think it is important to break the question into its two parts. One part addresses the proposal to create individual retirement accounts while the second addresses the steps necessary to change the funding or benefits of the existing system to provide a reasonable chance of removing its long-term financial problems.
Q2.1 What would private retirement accounts do for participants?
The idea of individual retirement accounts would begin to shift the country's retirement security system from a pay-as-you-go system (in which today's wage earners pay taxes to support today's benefit recipients) to a system in which funds set aside by today's workers would be invested and available (based on the returns over the workers' careers) to each individual on retirement. Of course, it would do little for today's workers nearing retirement, since their contribution window is very short. However, it could provide a significant source of retirement wealth for young workers, with many earning-years ahead of them.
Not surprisingly the support for this element of Bush's plan has met with mixed support. A USA Today/CNN/Gallup Poll (Feb. 17) found that 49% of adults ages 18-29 thought the investment proposal was a good idea. However, only 31% of adults 65 and older thought it was a good idea.
This generational disagreement derives at least in part from the fact that 65 and older adults likely perceive the proposal as weakening the source of funds for their expected Social Security benefits, while the 18-29 year-olds probably expect that Social Security (in its present form) holds little hope of being solvent when they retire. While this promises to be a source of generational conflict, it should be recognized that this proposal does not address the funding challenge the current system faces (more on that below).
Beyond the promise that such a proposal might hold for younger workers, investors are asking "what will such a proposal do to the equity financial markets?" At first glance, privatizing a portion of Social Security contributions (and the dramatic money flows going into stocks) would seem to be a slam dunk for broad price appreciation in equity markets. But my view (as any good economist's) is — "maybe".
Although private accounts may provide a large inflow of funds into the US stock market, remember that there are other stock markets as well that compete for worldwide investment dollars. If US equity prices are driven so high that our market becomes overvalued, it's likely that investment managers would begin moving money out of the US and into markets perceived to be better buys — such as Australia, Canada or Europe. It is also possible that the assets set aside in the program could diminish incentive for further investment by households. These could offset any gains coming from the impact of private contributions, so the net effect may be minimal.
Q2.2 "What changes to Social Security will be necessary to deal with the funding problem? Do you think it will happen?"
While it's far too early to know for certain, history tells us any such changes will be a difficult sell with Congress. Dealing with Social Security has always been exceedingly difficult for the US government, because making changes often means inflicting economic pain on at least a segment of the voting population — reducing their benefits and/or increasing the amount they contribute.
Any official thinking about re-election is going to think twice about reducing the size of a constituent's pocketbook. Funding Social Security with pay-as-you-go measures today, when just 23% of the population (2003) is 65 years and older, is a lot easier than it will be in 2030 when the Census Bureau estimates 41% of the US will be 65 and older. We need to do something.
Putting politics aside, many financial thinkers consider Social Security not as a program designed to return everything you've put in with interest, but as a program designed to enhance the economic security of the entire country.
When I talk to economists, the suggestions I hear most often are that the retirement age should be raised, that the index of benefits should be tied to consumer prices rather than wages, and that the cap on wages subject to Social Security tax should be raised. Any of these would mean that many people — not just the billionaires of industry — will pay more into the system than they get back.
While I'm not making any predictions, it could be done. Our pay-as-you-go system is not necessarily the ideal approach; I often wonder why my kids are paying taxes into a system that winds up paying me the benefits (especially if their incomes are lower than mine).
Most experts agree that Social Security should provide a safety net that assures no senior citizen is ever forced into poverty after years of hard work. But beyond the safety net, retirement security certainly could be enhanced with market-based investments. While you can't totally eliminate people making ill-advised investment decisions, you can build a playing field that makes the most of people's intentions.
Putting retirement contributions into a relatively limited choice of highly diversified — make that extremely diversified — portfolios is worth consideration. Such retirement-designated portfolios don't have to be the most stellar performers to provide a return over and above the current Social Security system. Indeed, this approach is the one taken by the Australian government through a limited selection of superannuation retirement funds.
"With all the common sense you bring to the picture, how about Professor Portfolio for President in 2008?"
I'm enough of a sucker to believe some of the people actually meant this whimsical question. I admit I'm flattered by any such sentiment. But have no fear; I have no intention of running for elective office. It's too taxing a job, it puts great strain on you and your family, and it takes an ego that I'm personally not certain I have. And let's face it, with my willingness to make the changes I've mentioned above, I'd have zero chance of being elected.
But just like you, I'll be watching Washington closely to see what happens. In the meantime, please keep your questions and feedback coming; like any good representative, I pledge to address your concerns in future columns. 
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