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 for a variety of reasons, its dominance faded over time. Today, the Netherlands ranks seventeenth 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 come to mind are the regular ebbs and flows of the economy that last perhaps a few years at a time. In the past 30 years, for example, the U.S. has experienced four recessions and recoveries. These are the sorts of cycles we’re used to, and in financial planning, these are the sorts of cycles that get the most attention in thinking about risk management.
But we can learn something important from the Netherlands: In addition to the regular economic cycles we’re used to, there is another, entirely different type of cycle—one that can last decades or even centuries. These are more tricky for two reasons: First, they are so long that they begin to create an illusion of permanence. To someone living in Amsterdam during the Dutch Golden Age, for example, it probably would have seemed unthinkable that the country would one day fall to number 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 of 1989. Today, more than 30 years later, the Nikkei still remains about 20% below that 1989 peak. But its market has been showing more 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 might 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. Today, at least three economic trends are confounding investors.
1. Real estate: Real estate has always been very cyclical. But despite periodic downturns, historically it has 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 that will eventually see a recovery?
2. Inflation: Before inflation picked up last year, the United States had enjoyed inflation so low that consumers and investors barely gave it much thought. In the 1990s, inflation averaged 3.0%. In the 2000s, inflation averaged 2.6%, and in the 2010s, it averaged just 1.8%. 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 actually 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: Interest rates are another question confounding investors. After peaking in 1981, interest rates in the U.S. declined in more or less a straight line for about 40 years. From a peak above 15% in 1981, the 10-year Treasury bond rate declined to near 0% in the spring of 2020. So how should investors think about today’s interest rates? The 10-year bond now stands at 3.6%. 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. So are today’s higher rates 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, for example, stock market index funds. For years, according to the data, index funds have consistently outperformed their actively-managed counterparts. So it seems like they’ll be the right choice for the foreseeable future, but 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 a few recommendations:
First, recognize the reality that nothing lasts forever. Thus, 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 number of 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 bit far-fetched. I’m not sure you need to worry right now about the United States falling into seventeenth 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 might be necessary.
