by Rob Bennett

A popular explanation of the Lost Decade Plus Two Years for stock investors is that it is the product of demographic changes. When Baby Boomers reached an age at which they needed to provide for their retirements, the demand for stocks increased so greatly as to push prices to the moon. But once Baby Boomers got close to retirement age, investors anticipated huge selloffs and prices dropped hard.

The effect is probably not great, according to the Valuation-Informed Indexing Model for understanding how stock investing works.

Demand for stocks doesn’t matter, according to the VII Model. Demand of course has a temporary effect. When lots of investors want to own lots of stocks, that pushes prices upward. But it is a key precept of this model that, while prices often do not reflect the economic realities in the short term, they always do in the long term (that is, after the passage of 10 years or so of time). Demographic changes could push stock prices up hard or down hard for a time. But demographic changes do not alone determine true value. To the extent that demographic effects only affect the demand for stocks and do not affect the productivity of the economy, demographics have an effect only in the short term.

Demographics are like a lot of other potential factors. Some suggest watching inflation rates to know where stock prices are headed. Some say to watch political developments. Some say to watch consumer confidence. The Valuation-Informed Indexer views all of these as temporary effects. They can affect perceptions of value. But generally they do not signal permanent changes in stock values. The U.S. economy has been sufficiently productive to support a 6.5 percent real annual return for as far back as we have records. So long as that remains so, you don’t need to be concerned about any non-valuation factors if you are investing for the long run.

Valuations are the exception.

Why?

The effect of inflation can be priced into the nominal market price. The individual investor need not worry about assessing how much a change in the inflation rate will affect the value of stocks because lots of other smart investors are performing the assessments needed to set things right. The same goes for political developments and consumer confidence and demographics.

There’s one factor that can never be priced in, however — Valuations. Both overvaluation and undervaluation are mispricings. How can a mispricing ever be priced in? If mispricings were priced in, the mispricing would no longer remain in place. If investors factored in the effect of valuations, stocks would always be priced at fair value.

So valuations do matter. A lot. Demographics, not so much.

The mistake that most people make (according to my perspective!) is in thinking that the stock prices they hear reported on the radio must be real because they seem so — official. Everyone seems to agree that the price reported is the price that matters. So we give it respect.

The reality is that the reported price is by definition not the price that matters. Not at a time when there is overvaluation or undervaluation present. If there is overvaluation or undervaluation, the nominal price is not the lasting-value price. The lasting value price is the nominal price as adjusted for the effect of overvaluation or undervaluation.

Demographic changes can cause temporary price changes. Just about anything can. All that an effect needs to do to have a temporary effect on prices is to influence investor psychology.

But only factors that cause permanent changes in the productivity of our economy can affect long-term returns. Demographic shifts could do that. So I cannot rule out the possibility that demographics could have some effect on long-term returns. However, the reality is that the 6.5 percent real number has remained the average long-term U.S. stock return for a long, long time. For a demographic change to affect that number in a substantial way, it would have to be one highly dramatic demographic change.

Rob Bennett has written about what he likes and doesn’t like about Robert Kiyosaki. His bio is here.