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Portfolio > Portfolio Construction > Investment Strategies

What's Behind Us Is the Future

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Any serious discussion about the management of wealth or how to invest should begin with a basic understanding of human behavior, of when and why people do things. This basic understanding includes two simple insights: that human behavior is measurable and that it is predictable.

If you know the size of a population–for example, that of the entire United States–you can then quantify, calculate, gauge, and determine probable outcomes based on the predictability of that population. According to reports from the U.S. Government, the predictable spending behavior of the U.S. population drives 70% of our economy. The U.S. Department of Labor conducts an ongoing Consumer Expenditure Survey that measures how much people spend per year, down to the penny, on over 1000 different items. Likewise, this collection of numerical data shows how, in very predictable ways and at predictable ages, consumers greatly reduce spending. (You can access this survey at www.bls.gov/cex/.)

If you know when specific populations enter the workforce, when changes in the workforce take place, when spending is at its peak and when people are spending money on houses, cars, travel, healthcare, etc.–and the opposite–you can make some predictions with a fairly high probability of success.

Let’s use the average adult female for a snapshot of these patterns. At 25 years of age, the average woman marries, purchasing wedding-related goods and services. She has her first child at age 27, when she buys child-focused items such as baby food and clothes. She’ll close on her first home at age 31 and will fill it with furniture and other home-related products. Her child is now 14 and at the peak of his calorie intake, eating her out of “house and home.” This is why the largest purchaser of potato chips is a 41-year old woman. Corporate America bases much of their product marketing decisions on the same consumer spending data down to the zip code and neighborhood block.

At age 43, the woman has enough home equity and income to sell her first house and move on to a larger, more expensive home–probably the largest and most expensive one she’ll ever own. She spends the next three years purchasing more high-end goods than she likely ever will again, including extensive new landscaping, furniture, and a luxury car.

In the meantime, her teenager turns 19 and is ready to enter college. The woman’s belt tightens as hefty tuition bills arrive and retirement looms closer. Next, her retirement clock starts ticking, the woman’s saving habit kicks into overdrive beginning at around age 55, and she continues to save until she retires at age 65.

Peering into the Crystal Ball

Just as we can predict the types of products and services that consumers buy at certain ages, we can also determine the quantities of those products and services that will be bought and sold by studying U.S. census data. The Census Bureau literally goes out and counts people. Corporate America then bases product-marketing decisions on the data drawn from this amalgamation of zip codes and demographics. Your local grocery chains use the data to determine when to open new stores in a particular area, when to close stores in others, and how to re-stock store shelves as their local shopping populations mature. It’s not a coincidence that a huge number of teenagers live in my own neighborhood and within a two- mile radius we have a Super Safeway, a Super King, and a Super Albertson’s.

Since these predictable spending patterns affect company earnings, and company earnings are reflected in the price of publicly held stock, observing these patterns can provide a window into the future. Why then aren’t we as an industry using this type of knowledge to manage our client’s wealth? Why are we stuck in a world that can’t mention the words “predict the future” then turns around and bases investment decisions on past performance? Two reasons: the first goes back to the day when investment management was about “do no harm,” and the second is that historical trends are easier for us to summarize and explain to our clients. As an industry we tell people that no one can predict the future–a statement often followed by advice on where to invest.

Past performance operates much like the odometer on your car. An odometer looks backward; it isn’t designed to tell you how many more miles are required to reach your destination, or other helpful information. Historical data on investment vehicles has some value but it is in reality, just like the odometer, a picture of the past. It would be more useful to have an odometer giving a fair estimate of how many miles to your destination versus your current fuel level. What would be more useful than a graph historical investment returns would be a tool providing a fair estimate of what might reasonably be expected in the future, which is what the consumer spending data does.

Spending data does have an impact on the future, yet it isn’t factored in to risk return graphs, style analyses or Morningstar data, all of which is based primarily on past performance. These types of strategies are based on predicting winners from past performance. Historical performance has become so hardwired into the investment profession’s delivery system that we need to stop and think about it. This approach creates frustration for investors who become, in effect, market timers–often firing investment advisors and hiring new firms in hopes of gaining back lost ground; the classic buy-high, sell-low syndrome results. Finally, investors become disillusioned with the never-ending process of picking new actively managed investments, and some give up altogether.

I believe we must start taking responsibility for the future and stop using past performance as an indicator of what could be. Instead, we should stand up and say what we see: that certain patterns do have predictable outcomes. Take healthcare for example, I believe the next big spending spree in the U.S. will occur in this area. All you have to do look around and see that our population is getting older, then let your brain link old age to healthcare. You don’t need an economist to tell you this.

I hope you’re starting to see why this information is so important to you and your clients.

In our current financial environment of inescapable media exposure, conflicting and/or inane information carries the same weight as valuable information. As a free society, we are privileged to have total availability and disclosure of all information, but that also includes worthless opinion and sales hype. We need to educate ourselves in order to make “intelligent” investment decisions and have the discipline to help eliminate bad ones. By the way, you won’t find the following factors studying modern investment or academic theory, or by reading the popular bestselling investing books.

Registered Births 1910-2004

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Birth Rate

The National Center for Health Statistics (NCHS) tells us how many people are born. Birth rate determines the size of a generation. Thus, birth rate charts tell us decades in advance when new generations of consumers will move through predictable earning and spending cycles.

The above graph tracks birth rates since 1909, which is when birth data began being collected on a yearly basis. Our population appears to have peak growth in 40-year cycles. There was a peak in the birth cycle in 1921 that has been dubbed the ‘Bob Hope’ generation; and another in 1961, well known as the Baby-Boom generation. The ‘boomer’ generation is notably over four times the magnitude of the past generation and overshadows its own offspring generation. Our baby boomer generation is so massive that everything it does has stretched our society and economy to extremes.

What’s Behind Us Is the Future!

A large group of people (boomers) is moving forward in time, which indicates a large drop in population (less people to spend). What that means is that advisors still relying on so-called ‘life stage’ allocation charts that suggest client age, emotional state and time horizon are the criteria with which to prescribe the right investment strategies or vehicles is, they could easily decimate their clients’ portfolios.

Average Annual Family Spending By Age

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Spending Goes in Waves

The exhaustive survey compiled by the DOL is based on consumer diaries of expenditures in which items as small as vending machine purchases are noted and considered.

This chart shows the “Predictable Spending Cycles” of the average American family; but, it also reveals, on average, when family spending starts to decrease. When the kids are gone, a big house is no longer needed. There is less need to replace furnishings and appliances, to keep the refrigerator crammed with food, or buy trendy tennis shoes and designer clothes. Parents typically mourn the loss of their kids until they realize they are at the top of their earnings cycle, with a massive drop in financial obligations. They still have the fixed costs of a home and furnishings but variable costs can suddenly drop by as much as half. This translates into more money to spend or invest.

By studying spending waves, you get a clear picture nearly five decades into the future of when the economy should grow, stall, and decline. The more you can predict, the more you can manage the economic impact on your own wealth. This does not require you to make a leap of faith. An understanding of spending waves may be one of the most important components missing from the financial planning model. Our earlier example was that the biggest buyer of potato chips is a 41-year-old woman. In order to understand how consumption will affect the potato chip industry, all we need to know is how many 41-year-olds there are, and whether this number is increasing or decreasing.

Product Life Cycle

Observing consumption reveals that the “Product Life Cycle” also gives us our last factor–the seasons of the economy. You can combine all this information and develop your own forecast of long term economic seasons, and sectors where you expect future economic growth.

Economies have cycles just as products do. The classic industry cycle is: Innovation, Growth, Shake-out, and Maturity. There are different classes of spenders: innovators, early adopters, early majority, late majority, and laggards. Each group has specific attributes and adopts a product or service at a different point on the curve.

Let’s use this data to look at large cap, small cap, fixed income, and international equities and see how these categories fit into our consumer cycle.

If we overlay the demographics and the product lifecycle, we get a structure for forecasting economic change. We can then develop our forecast of long-term economic seasons and determine which areas of the economy should be outperforming in the years to come. We already have knowledge of what people will be buying, but now we can match where those products and services are in their product lifecycle. Can you see how this knowledge would be invaluable when added to the investment process? It also answers the question of why different sectors perform so differently over time.

Seasons of the Economy

These stages create our “Four Seasons” of the economy. You can see that there are two different booms and two different busts over the same four-stage lifecycle that new products and technologies go through.

These four “seasons” represent long periods of time wherein the fundamental economic trends will generally go in one direction. The most important insight here is that these seasonal trends clearly favor some sectors of investments and disfavor others.

Success over the next two decades will depend on making the transition to a forward-looking process by solving the real needs of the new high-net-worth investors, the baby boomers, rather than simply playing the total return game. Frustrated clients will leave advisors who continue to manage using total returns as the primary measure. The winners will be advisors who transition out of the performance sale and enable their clients to meet and surpass their investment goals by looking to what is next.I believe that advisors need to understand that 70% of the economy is driven by spending. This means that you have to uncover your clients’ basic financial objectives: they either need more money, in which case you need assets that will grow during all seasons, or they want to protect what they have and not lose principal during any one economic season.

It’s also important that advisors understand there are seasons in an economy and learn how to identify and prepare for them.

Structure your clients’ assets in the most advantageous configuration; meaning how each asset is owned, titled, and controlled. For example, to maximize the tax code in your clients’ favor, allocate fixed income investments to pre-tax accounts (it is taxed as ordinary income on distributions) and growth in after-tax accounts (growth generally has higher returns and will be taxed at the lowest capital gain tax rate). Having the proper structure is also a crucial component in transferring assets to the next generation with the least amount of federal estate tax possible.

Lastly, explore the seasons of the economy to get a global perspective on how to apply this type of information. Then use your insight to predict trends in your overall effort to first grow and then protect your clients’ wealth.

Economic Cycle and Investment Strategies

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James Lunney is a CFP and creator of The Wealth Planning Strategy. He can be reached at [email protected]. Securities offered through Linsco/Private Ledger member SIPC.


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