Government Policies and Your Investment Portfolio

Last February, Newsweek magazine ran a cover story entitled “We Are All Socialists Now” in which the authors, Jon Meacham and Evan Thomas wrote: “The America of 2009 is moving toward a modern European state” and “more government intrusion into the economy will almost surely limit growth as it has in Europe, where a big welfare state has caused chronic high unemployment” (Newsweek, February 16, 2009).

Many investors are concerned about the prospects of increased government involvement in the economy and are asking questions like “how are we going to pay for all of this spending”, “won’t the bigger deficit have to lead to higher taxes and higher inflation” and “how can that be good for economic growth?”  I share many of these concerns.  But an entirely different question is, “does this change the way we should invest?”  In my opinion, the answer to that question is no.

The first thing to keep in mind is that government involvement in the economy is not new. In 1917, President Woodrow Wilson assumed control of the railroad industry.  In 1933, President Roosevelt launched the Tennessee Valley Authority to compete directly with private industry. During World War II, the national debt exceeded 120% of GDP, and in the 1950’s, the top tax rate topped out at 90%. Despite all of this government involvement, the US economy survived and the US stock market provided annualized returns of 9.5% from 1927-2008 (Source: Dimensional Fund Advisors, 2009 Matrix Book, US Total Stock Market Index).

The next thing to consider is that the degree of government involvement in the economy cannot necessarily be used to predict stock market returns.  Weston Wellington of Dimensional Fund Advisors provides the following example.  If we look at the 39 year period ending December 31, 2008, we would find that Sweden, a country normally associated with a very high level of government involvement in the economy, enjoyed annualized stock market returns of 12.86%.  During that same period, the US stock market experienced annualized returns of 9.12%. (MCSI data copyrighted 2009)  This is not an argument in favor of adopting the Swedish economic system, but it is just a way of demonstrating that the government involvement in the economy is just one of many factors that affect stock returns.

And finally, while political risk is real, it is still a risk for which investors must be compensated. The market is constantly adjusting prices to take into account all of the risks of owning stocks, including political risk. When risks go up, stocks are likely to adjust downward to provide investors with higher returns going forward, and vice versa.  Unless you can do a better job than the market in predicting policy changes and the precise manner in which these changes might impact investment returns, in my opinion, the best way to deal with political uncertainty is to diversify as much as possible.

While there are valid concerns over deficits and inflation and the impact of increased government involvement on economic growth, these concerns do not necessarily mean that investors should change their approach to investing.  In my opinion, the best approach continues to be as follows: design and implement a low-cost, broadly diversified global portfolio designed to meet your financial planning objectives, and stay disciplined.