Will retiring boomers spark a stock bust?

As if equity investors didn't already have enough to worry about, one of the new concerns getting a lot of attention recently is that the baby boomer cohort -- now starting to retire -- will fund their retirement by selling equities. The "conventional wisdom" is that this supposed sell-off will result in a stock market bust.

It's certainly true that the population is aging. In 1980, the ratio of workers to retirees was 5.2:1, and by 2025 it's projected to be just 2.9:1. But that doesn't necessarily mean the stock market will take a big hit.

To help you understand why, we'll begin by pointing out that only unexpected events have an impact on stock prices. And if anything can be forecasted, it's demographic data. You can be certain that investors in general are well aware of this trend, and thus have incorporated that knowledge and the expected effect of retirees' equity sales into current prices.

Only if the level of equity sales is greater than expected should there be a negative influence on future stock prices. And it's certainly possible that sales will be less than expected. Or that equities will see an unexpected offsetting increase in demand from other sources. Or that retirees will remain in the work force longer than expected.

If any of these scenarios occur, and all else remains equal, equity prices may actually increase.

The lesson here is that you shouldn't confuse information with wisdom, or above-benchmark returns.

With this understanding, let's review a recent white paper by Vanguard's investment research team that examined this same issue. They provided five reasons they believe concerns over a market bust brought on by baby boomers' retirement-induced equity sales are overblown.

1. The boomer cohort spans 20 years, so they won't all retire at once, and any sales should be spread out over time.
2. While baby boomers' share of total equity holdings increased as they aged -- from 24 percent in 1998, to 32 percent in 2004, to 47 percent in 2010 -- their share of total equities is similar to that of prior groups of 46- to 64-year-olds. For instance, that group held 46 percent of equities in 1992, 53 percent in 2001 and 44 percent in 2007.
3. Baby boomer wealth is highly concentrated, with the wealthiest 10 percent holding 90 percent of the assets. The wealthy will not need to sell equities to meet short-term spending needs.
4. Global demand for U.S. equities is increasing. Foreign holdings of U.S. equities rose from 7 percent in 1990 to 21 percent in 2012. Any selling pressure from retirees could be offset by the growing foreign demand.
5. There's no historical relationship between retirees as a proportion of the population and U.S. stock returns. A multicountry study also found virtually no correlation.

This last point is supported by earlier research from Jim Davis of Dimensional Fund Advisors. (Note: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.) In his 2005 whitepaper, "Demographics and Stock Prices," Davis noted that the evidence actually suggests investors "accumulate equity positions during years of their greatest earning power and do not dramatically reduce those positions as they enter retirement."

In the end, Vanguard recommended that investors avoid making hasty decisions on their long-term asset-allocation plans based on the baby boomers' impending retirement.

Because today's market valuation is based on all information that is knowable about the future, it's likely that currently unforeseeable events will have a far greater impact on prices than demographic shifts. And because what we don't know is by definition impossible to forecast, the biggest impact on equity markets will likely come from events that few, if any, even have on their radar screens.

You're best served by ignoring market forecasts. Instead, focus on the things you can actually control: the amount of risk you take, how well you diversify the risk you decide to accept (for example, eliminating or minimizing diversifiable or idiosyncratic risks from single companies, sectors and countries), keeping costs low and maximizing tax efficiency.

And finally, because future returns are likely to be shaped by events that aren't forecastable is why investors have historically demanded a large premium for taking equity risk. It's also why equities are risky no matter how long your investment horizon. Believing that equity risk declines as your investment horizon increases is yet another example of the conventional wisdom being wrong.