Zero sum thinking

One of the objections to converting social security to a system of private accounts is the fear that private accounts won't keep up with the demand for benefits. Stocks are volatile, and a sudden fluctuation in the market could wipe out the whole system. The fact that, as a whole, the market has returned 7%, adjusted for inflation, doesn't address this concern. As the ads all say, "past performance is no guarantee of future results."

what is needed is an explanation of why equities outperform social security.

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When one buys equities one buys titles to a share in a firm. The value of any firm is its discounted anticipated earnings. If a firm doubles its earnings and these are thought to be permanent then the value of the firm will also double. A progressing economy is one that is accumulating capital. This means that productivity will be rising and so too the value of total output. It therefore follows that the value of equities must also be rising.

In other words, as people produce stuff, we have more stuff. When we have more stuff, we can do more things with it. This seems to fly in the face of at least one economic theory:

According to standard economic theory “the higher return on stocks is related to their greater risk”. (Garry Becker, Wall Street Journal, A Political Case for Social Security Reform, 21 February 2005). But if this view were correct there would be no profits. As a progressing economy is one that is accumulating capital it is by definition one in which entrepreneurial profits exceed entrepreneurial losses. And capital gains are profits. No one in his right mind, for instance, would argue that the returns to Microsoft over other assets can be explained by a risk premium.

Standard economic theory appears to treat stocks, and the stock market as a whole, as a zero-sum game. In a zero-sum game, the available resources don't change. If one person gains, it must represent a net loss for the rest of the universe.

In the largest sense, though, it's obvious that the market is not a zero-sum game. The available resources have been increasing over the centuries. Were this not the case, the planet's standard of living would have dropped through the floor decades ago. Instead, as only one of several measures, we see per-capita food production rising.

Increased productivity over time produces real gains in resources, and this shows up as a real increase in the value of the companies that own them.

Since stock is partial ownership of companies, it is partial ownership of resources. That portion of their increase in price that reflects increased value is real, and independent of market risk.

Reliance on zero-sum thinking where it doesn't apply, just like reliance on any bad theory, will cost you in the end.