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IN THE NETHERLANDS in 1602, the Dutch East India Company conducted the world’s first initial public offering. Then, in 1610, the Netherlands saw the issuance of the first ever stock dividend. And in 1611, when the Amsterdam Exchange opened, the Netherlands became home to the world’s first stock market. Throughout the 1600s, the Netherlands continued to see further financial growth and innovation.
During that period, the Dutch economy was among the world’s largest. But its dominance faded over time, and today the Netherlands ranks 17th in terms of GDP among world economies—behind Russia and Mexico.
This highlights an important aspect of economic cycles. Usually, when we think of cycles, what comes to mind are the regular ebbs and flows of the economy that last perhaps a few years. In the past 30 years, for example, the U.S. has experienced four recessions and recoveries. These are the sort of cycles we’re used to and, in financial planning, they’re the sort of cycles that get the most attention when thinking about risk.
But we can learn something important from the Netherlands: In addition to the regular economic cycles we’re used to, there’s another, entirely different type of cycle—one that can last decades or even centuries. These are trickier, for two reasons. First, they’re so long that they begin to create an illusion of permanence. To someone living in Amsterdam during the Dutch Golden Age, it would probably have seemed unthinkable that the country would one day fall to No. 17 among world economies.
The second reason these longer cycles are tricky: Because they don’t have a regular rhythm, it’s hard to know what to make of them. In mapping out a financial plan, how can you account for something that you might or might not even see in your lifetime?
Consider Japan’s Nikkei 225, the equivalent of our S&P 500. After a boom in the 1980s, the Nikkei hit a peak in December 1989. Today, more than 30 years later, the Nikkei remains about 20% below that 1989 peak. But its market has been showing signs of life recently. That’s great, but it’s also confusing. Does this mean that, in making plans, investors need to consider the possibility of—and be prepared for—stock market downturns that could last as long as 30 years?
Japan’s experience might seem like an outlier case. And perhaps it is. But closer to home, we’re currently witnessing some unusual financial cycles of our own. At least three economic trends are confounding investors.
1. Real estate. Real estate has always been very cyclical. But despite periodic downturns, historically it’s rebounded and come back stronger. Today, however, real estate investors have a more serious concern: Because the work-from-home trend doesn’t seem to be going away, many are wondering if commercial real estate is facing an existential threat.
Office vacancy rates have remained high. And while still anecdotal, there have been stories about office buildings being sold at steep losses. Many buildings have changed hands at prices 30% or more below where they stood before the pandemic. In San Francisco, a building that was valued at $300 million in 2019 recently sold for less than $70 million. The question investors are asking: Is commercial real estate permanently impaired, or will this turn out to be just part of a longer cycle and we’ll eventually see a recovery?
2. Inflation. Before inflation picked up last year, the U.S. had enjoyed inflation so low that consumers and investors barely gave it much thought. Inflation averaged 3% in the 1990s, 2.6% in the 2000s and 1.8% in the 2010s. Go back to the 1980s, however, and inflation was in the 5% range, and it breached 10% in the 1970s.
This has left investors wondering how to think about inflation. Is today’s inflation rate—most recently at 5%—an aberration, or was the aberration that earlier period, between 1990 and 2020, when inflation was so low for so long? This isn’t just an academic question. It has practical implications for anyone making a financial plan.
3. Interest rates. These are another issue confounding investors. After peaking in 1981, interest rates in the U.S. declined in more or less a straight line for four decades. From a peak above 15% in 1981, the 10-year Treasury note yield declined to near 0% in 2020.
So, how should investors think about today’s interest rates? The 10-year note now stands at roughly 3.7%. That’s demonstrably higher than it was two years ago but no higher than the rates we saw in the 2000s, prior to the financial crisis. Are today’s higher yields an aberration, or was the aberration that earlier period, when the Federal Reserve held rates so low for so long? This is an important question, especially for those in retirement. Can they expect to continue earning 3% or 4% on their bonds over the long term, or should they assume rates will drop back down?
These are the most obvious open questions. But in reality, there may be other cycles underway which are so slow moving that we don’t even realize they’re cycles. Consider stock market index funds. For years, according to the data, index funds have consistently outperformed their actively managed counterparts.
It seems like they’ll be the right choice for the foreseeable future. Still, index funds might one day go into decline. I’ve discussed, for example, a strategy known as direct indexing that’s been growing in popularity. Perhaps this will supplant traditional index funds. Or perhaps, as some have argued, index funds’ success will sow the seeds of their own demise.
How should investors respond to this kind of uncertainty? I have three recommendations. First, recognize that nothing lasts forever. You want to avoid becoming too attached to any single investment or way of investing. Periodically question whether the approach you’ve been using still makes sense.
Second, maintain a diversified portfolio. How diversified? Here’s the litmus test I use: You should always have some holdings in your portfolio that annoy you because they’ve been lagging for a while. If that’s the case, then you should be well positioned to benefit when the cycle turns for those particular investments.
Finally, in making a financial plan, think through a set of scenarios that seem just a little far-fetched. I’m not sure you need to worry right now about the U.S. falling to 17th place behind Russia and Mexico. But in making your plan, look for ways to build in just a little more margin for error than you think necessary.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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Direct Indexing: What Is Direct Indexing? How It Works, Benefits, and Downsides (investopedia.com)
Another good article Adam! As Bill Bernstein has written, you can’t learn too much about financial history.
But in making your plan, look for ways to build in just a little more margin for error than you think necessary.
Key point! I’ve planned for 100% gross income replacement in retirement to provide that margin of error. When I have a bad day at work, I am tempted to fall back to guidelines suggesting that 75% or 80% or 85% of income replacement is ample. Then I remind myself that I usually enjoy my work and that a little margin for error is important.
Excellent post, Adam, as always. I’m glad you post on Sunday, when I have time to read and reflect.
I like your method of building in your own margin of error.
Adam, thanks for the interesting and intriguing article. It’s valuable to maintain a long-term view, and a longer term hindsight. I find it helpful to recognize that we’ve seen, and survived, worse times. It helps me keep perspective.