Did the crash of '87 teach us a lesson?.....the great bull market the middle class missed.....the single biggest force pushing the bull market......

Betting on the Market

Interview with Ron Chernow.

Ron Chernow is the author of "The House of Morgan" and "The Warburgs."

Q What did the mutual fund companies have that spoke to the Boomer?

The mutual funds have historically offered safety and diversification. And they spare you the responsibility of picking individual Ron Chernowstocks. Now it's interesting. In the 1920s, mutual funds were introduced under the name of "investment trusts". And there were two qualities about the mutual funds of the 1920s that made them extremely speculative. One was that they were heavily leveraged, that is, they made a lot of investment with borrowed money. Two, mutual funds were allowed to invest in other mutual funds. And the guaranteed that in a market downturn they would all drag each other thunderingly down together, which is exactly what happened in 1929. Now although the brokerage industry fought a lot of the securities reforms of the 1930s, the one aspect of the financial services industry, the one part that was very, very receptive to having strong regulation, was the mutual fund industry, because they realized that if they had very strong regulation to protect investors, it would actually bolster public confidence in mutual funds. And that was actually a brilliant strategic position that they made. They were never hostile to regulation from Washington. They always felt the stronger the regulation, the greater the public confidence in mutual funds. And to this day, the mutual fund industry, instead of having the traditional antagonistic relationship with Washington, has had a very harmonious relationship with Washington.

Q How safe are mutual funds really at the end of the day?

Let me give you some figures just on the growth of the mutual funds, to give you some sense of how staggeringly large and complex the capital markets have become. If we go back ten years ago, there were about 1700 mutual funds with about $700 billion in assets. Today, we have about 7,000 mutual funds with $3 trillion worth of assets. There are so many funds and so many stocks and so many bonds and so many warrants and so many options, it's such a dizzying universe of choice for people that, inevitably, they're attracted to any sort of professional management of people who can help them to hack their way through this thicket of different offerings. And I think that in the last decade of the 20th century we have so many thousands of companies being publicly traded and so many hundreds of new companies going public all the time, that it has just outstripped the ability of the average individual to keep up with all of the possible investment opportunities.

I also think that there's enough of a lingering suspicion that market insiders have some kind of unconquerable edge over the little people that mutual funds give people the sense, perhaps the illusion that they're investing with the big boys and that they're really not at a disadvantage in entering the stock market.

Q Do you think it is an illusion?

The best argument for mutual funds is that they offer safety and diversification. But mutual funds don't necessarily offer safety and diversification. They can be converted to quite speculative purposes. I think that when the great bull market began, many more of the mutual funds were investing in the big blue chip companies, so it seemed like a safe cross-section of companies that were very safe buys to begin with. What happened over the course of the bull market of the 1980s and 1990s is that we have more and more speculative mutual funds. So that I don't think that a mutual fund that invests exclusively in biotech start-ups or invests exclusively in companies in Thailand offers any great safety or diversification, because all of the different components of those mutual funds will tend to respond in common to certain events. All the companies will move up and down together.

Q Why do people take that extra risk today?

There's a very powerful dynamic that sets in as any bull market continues. And the longer the bull market continues, the more powerful the dynamic. And the dynamic is this, that as the bull market goes on, people who take great risks achieve great rewards, seemingly without punishment. It's like crime without punishment or sex without sin. It almost seems too easy. And the guy at the next desk at work who's investing in some swinging little Internet stock or biotech start-up is making 50 percent a year. At that point you're getting seven percent on your Treasury bond or maybe 15 or 20 percent on your blue chip mutual fund. You begin to feel like you're some kind of a sucker or sap for settling for 15 or 20 percent. And this guy who's getting 50 percent returns is laughing all the way to the bank.

And so that the whole risk/reward ratio is thrown out of kilter. And so that there are very powerful forces of both envy and emulation that set up. Also as a bull market continues, almost anything you buy goes up. It makes you feel that investing in stocks is a very easy and it's very safe and, most important of all, that you're a financial genius. By the end of the bull market everyone in America will feel that he or she is a budding J.P. Morgan and so it induces a dangerous feeling of invincibility. And so people are willing to tolerate a greater and greater amount of risk.

Q Talk about cleansing effect of the crashes to burst the bubble and how that has changed today.

Stock market corrections, although painful at the time, are actually a very healthy and necessary part of the whole mechanism of the stock market, because there are always speculative excesses that develop, particularly during the long bull market. And corrections give the market an opportunity to wring out these excesses, so that big dangerous bubbles don't develop. One of the things that has disturbed me in recent years is that I think that we have lost the ideal balance between fear and complacency. You don't want too much fear in a market, because people will be blinded to some very good buying opportunities. You don't want too much complacency because people will be blinded to some risk. I think that there's a kind of institutionalized complacency in the market now. So many people have been told to buy and hold forever. So many people steadily drip money into the mutual funds every week or every month through their retirement plans or through their 401K plans, that an enormous amount of cash tends to go into the stock market every week, regardless of what's going on in the American economy. And we applaud all of these little investors for being so sound and so sensible. And that strategy of buy and hold, which is the sound and sensible one for the individual, I think can have very dangerous and perverse effects for the market as a whole, because there's so much cash pouring into the market. It's constantly riding up on their tremendous wave of cash, that it's going up in a straight line without the natural, healthy and necessary opportunity to correct. What we haven't seen during the bull market of the 1990s is a nice kind of ebb and flow where the market periodically corrects and speculative excesses are, wrung out. And it makes me worry whether there's a dangerous complacency that is building up here and that by being spared lots of little corrections, that we're setting ourselves up for something much bigger and scarier at the end of the day. I don't necessarily think that will happen but it am concerned because as we talk, the stock market rally has gone on for six years with scarcely a correction.

Q How new is the idea of large numbers of American small investors coming into the market?

It's really almost a brand-new idea, Joe, because if you go back to the great bull market of the 1920s, it's estimated that there were only between 1.5 and three million investors. In the 1950s we had only six million investors in the stock market. By the 1960s, 20 million. Today, in the 1990s, we have at least 50 million people who are invested either directly in stocks or in mutual funds. And if you add in people who are covered by corporate pension funds, you can produce figures as high as 100 million. So this is a vast expansion. The American public historically was really not part of the stock market.

Q What's brought them in?

Well, if you go back to the turn of the century at the time of J.P. Morgan, the world of high finance was completely wholesale. That is, the prestigious investment banks on Wall Street appealed exclusively to large corporations, governments, and to a very select clientele of extremely wealthy individuals. It was only in the 1920s that, for the first time, there were any Wall Street institutions that appealed directly to small investors. In the 1920s a lot of the large banks on Wall Street set up securities affiliates. It was the first time that there was a large enough middle class investing public to make it worthwhile for banks to appeal to them. And as a result, we had close to three million people invested in the stock market by 1929. Had it not been for the 1929 Crash, that process might have continued.

Q What was drawing investors in, in the '20s?

Well, the Roaring '20s, it was a great effervescent bull market very much of the sort that happened in the 1980s, where there had been a post-war inflationary boom that was tamed by the Federal Reserve Board. There was disinflation. Inflation was coming down. Corporate earnings were rising and millions of people entered the stock market for the first time.

Q It was a more dangerous market, wasn't it?

It was a rigged stock market in the 1920s. Wall Street was a world that was really dominated by professional speculators and stock pools. These people really had a monopoly over information, and it was one reason why most little people did not invest in the stock market, because they thought that it was a rigged game. In fact, usually when the little people entered the stock market, it was a sure sign that the market was approaching a top. And when the little people arrived at the entrance, usually the smart money was heading for the exits. And so they felt that it was basically a game that was stacked against them, and they were right. And that's why the securities laws of the 1930s were so important, because it forced companies to file registration statements and issue prospectuses, and it really remedied what had been the great historic imbalance, which was an imbalance of information. It supplied the small investor with the same information for making stock decisions as had historically been reserved by the large investors. And that was really the thing that for the first time tempted large numbers of people to invest in stocks. What happened after 1929 was that so many people had been traumatized by the stock market crash that there was a lost generation. It was really only in the 1950s and '60s that enough years had passed that a new generation came along that had not been scarred by 1929 that rediscovered the stock market.

Q Were small investors in the same situation as large investors in 1929, i.e., they had borrowed everything?

In the 1920s you could buy stocks on margin. That is, you could put 10 percent down and borrow the rest against your stocks. And there were 600,000 margins accounts in the 1920s, which made it a very significant part of the market and it meant that a correction could conceivably turn into a crash, which is exactly what happened, that people were playing with borrowed money. But basically when the 1929 Crash occurred, Main Street probably cheered because Main Street was really not involved in the stock market of the 1920s. It was considered the sort of thing that racy and rather corrupt city slickers did. It was not considered a place for the whole family, as the stock market is considered today. And so when news of the crash came, probably a lot of people in small towns and farms across America felt a sense of grim satisfaction that the sinners had finally been punished for their wicked ways. Those people were still putting their money into passbook saving accounts or maybe stuffing it under the mattress. The stock market was considered much too risky for the average investor.

Q Talk about the great bull market of the 1950s that the middle class missed.

Well, very often investors tend to look backwards and the memories were so powerful and so haunting of what had happened in 1929, that even though there was a very vigorous bull market in the 1950s, it could only attract six million investors. Of course, it required the growth of a large middle class investing public to sustain the market. I think that one of the important things that's happened in the course of the century is that life expectancy has doubled.

And I think that much of what has driven the stock market over the last 20 years has to do with people planning for retirement. I think that there have been three great disenchantments that the American public has gone through over the last generation. I think one is that the public has lost faith in the ability of the welfare state, particularly, Social Security and Medicare, to provide for old age. I think that because of the S&L crisis, they've lost faith in the banking system as the repository for their savings. And then I think, finally, because of the growth of medical technology, people have lost faith in conventional medical insurance as a way of covering all of the contingencies and hazards of old age.

And so I think that what has been happening is a kind of fear, approaching a panic, that's spreading through the Baby Boom Generation which has suddenly discovered that it will have to provide for its own retirement. And because the traditional forms of savings have been discredited, people have become increasingly aggressive and, shall we say, creative in funding their retirement plans. And I think that that's a very important backdrop to what's going on, that it was only, for instance, in the 1920s that companies started pension plans because people were living longer and companies felt a responsibility to provide for people in old age. And a lot of the money in the stock market is really our national retirement plan, for better or worse.

Q Why didn't people have a sense of fear and panic in the 1950s?

Every generation, I think, has a defining economic event. For the generation before the Baby Boomers, the defining event was the Depression. And that left people very preoccupied with jobs and it created a generation of people who were very security oriented. When the Baby Boom Generation left school, the first great defining economic event was the Great Inflation of the 1970s. And it destroyed their faith in paper assets, because if you held a bond, suddenly the bond was worth much less money than it was before, and the interest payments on the bond were not keeping up with inflation. It destroyed their faith in the banking system. It had an ironic sequel, though, because in the 1970s it seemed to be the Great Inflation that destroyed faith in stocks. And yet I think the Baby Boom Generation, was so marked by the trauma of that inflation that in time, it was the very thing that led to their infatuation with stocks because they realized that over the course of time the asset that was most likely to keep pace with and stay ahead of inflation -- stocks.

Q What about houses?

Well, in the 1970s, houses were a wonderful buy because it seemed like that had been the traditional hedge against inflation and for a long time that worked. Finally that was discredited by the late 1980s and people realized that houses did not always appreciate and that they could fluctuate like any other market commodity.

... and what that meant, because I think the great bull market of the 1980s and the 1990s has been premised on the conquest of inflation. And if we go back to the 1970s, one of the reasons that there was such a generalized pessimism about the American economy is that a lot of people were convinced that inflation was actually a permanent and inerradicable part of the economy, the reason being that if you go back to the 1970s, there were very few parts of the American economy that were fully exposed to competition. Most of them were regulated, protected, pampered, or cosseted in some way. We had cartels in Smokestack America in auto, steel, and other industries that would follow a system of administered pricing and they would raise their prices together. We had regulation in transportation, communications, and prices were set. Entry was restricted. We had a military industrial complex that operated under cost plus contracts. Wherever you looked in the American economy, there seemed to be inflation built in rather than outright competition. We had very powerful unions that seemed to be pushing up the prices. And so it was really Paul Volcker's conquest of inflation that, snapped that psychology that inflation was a persistent and growing part of the American economy. And it was really Volcker's conquest of inflation that then set up this almost rapturous love affair with paper assets in the 1980s. But one of the things that happened in the 1970s was that we saw a massive shift of household savings from the banks to the brokerage firms, that the banks existed in a kind of regulatory straight jacket with interest rate caps and they could not pay interest rates that stayed ahead of inflation. And so a lot of people began to shift their money to brokerage house money market accounts that could pay market rates of interest. And this was actually a very good deal for consumers, who could get market rates of interest and who could also write checks against their money market funds. It was a wonderful deal for the brokers. For the first time, instead of bankers having control of your household savings and having a picture of your total assets, a broker was able to look at your money market account and see that totality of your wealth and how much money was available for savings. And once the brokerage house, rather than the bank, became the locus for American savings, inevitably, that money would find its way into the stock market, because the broker was someone with a much higher tolerance for risk than the banker.

I think that one of the things underpinning the great bull market of the 1980s and the 1990s is that a lot of the safe, stodgy traditional forms of investment have either been discredited or exposed as less safe than people had thought. And I'm thinking specifically of bonds, bank accounts, and housing. Those were the three things. If you we're going to be extremely safe and try to preserve capital, those were the three places that you would invest your money. And in all three cases, the Great Inflation destroyed faith in those three things. And I think that what happened was that when a lot of people suddenly realized that these supposedly safe investment could, under certain circumstances, be unsafe, they then took another look at stocks, which were supposed to be unsafe, and said, "Maybe stocks are safer than we realize." And I think that it was really at that point that stocks began to lose their stigma as a very risky investment because a lot of people felt betrayed. The different investments that they had been assured were rock solid and could never depreciate had, in fact, depreciated because of inflation. And so I think that it launched people into this brave new world of financial assets that they might never have ventured into otherwise, because it smashed a lot of the old chauvinism in terms of what constituted a safe investment. And at that point, the savings of the American public were really up for grabs.

Q Why in the '80s did the mutual funds have such a powerful hold on the Boomers?

The mutual fund industry has been very successful at promoting itself in this glamorous way. Mutual funds are actually vast, impersonal bureaucratic structures, and yet they were clever enough to pick out people like Peter Lynch and to give a human face to the mutual funds. And certain funds, like Fidelity, were so successful that a Peter Lynch could actually become a guru to a new generation of investors. I think, from a marketing standpoint, the mutual funds were also extremely clever by presenting families of funds, where it was very easy to move your money from one kind of mutual fund to another, because basically I think those who invest in mutual funds want someone else to do the thinking for them. But the fact that they can move the money around the family of mutual funds just through a phone call lets them feel that they can play tycoons and that they can allocate their money to different types of investment. And so that while the money is being professional managed, it allows them just enough autonomy that they feel like they are really the brains behind the operation and they are the ones who are making all of the money. So it was a very, very clever to do.

Now also what has happened is that have done a very good job of going to different brokerage houses and employers and selling their services and making these families of mutual funds the mainstays of many different retirement plans. And they did this at a moment in the history of Corporate America where corporations were very worried about the defined benefit plans. They found that very often they were guaranteeing a level of benefits that they had enormous amount of difficulty in meeting. So really under the impetus of the whole mutual fund boom, a lot of these companies switched to defined contribution plans, which essentially shifted the burden of risk from the companies to the employees, who might make a bundle from their mutual fund investments or who might not. It also meant that where under the old standard pension plan or even the defined benefit plan where the individual had no say in how the money was invested, it has forced many individuals to make very serious decisions about allocating their own money. It assumes a tremendous amount of sophistication among these investors, and I don't know how many of them really have it. Any bull market covers a multitude of sins, and so that there may be all sorts of problems with the current system that we won't see until the bear market comes. In fact, one of the valuable things about having even a correction is that it tends to expose the weaknesses in a market. When the market is just going up, up, and up, we all tend to be blind to the holes in the market. They're all papered over by the rise. And so we don't really know what the consequences will be of this great new national experiment where we're not using the stock exchange as a kind of souped-up turbo-charged national piggy bank and retirement plan.

Q Do you think that's an inappropriate way to use the stock market?

I think that there's a place for it. I think that there certainly is a place for the stock market in any retirement plan, but I think that it's a question of finding the right mix. I think that many who began to invest in the stock market in August, 1982 or if you started to invest in the stock market in 1990, now feel that they're grizzled veterans of the stock market. They feel that they've experimented anything that the stock market has to offer or to throw at them. In fact, they're investing experience, by historic standards, has been very narrow because they have known only bull markets, for the most part. They don't have a sense of how historically the stock market has been a very dangerous place, a place of wild swoops and dips, of stomach-churning gyrations. That's what the stock market has been. It's not a financial Disneyland (Laughs) or a Sears Roebuck. It really has some of the wildness of a gambling casino to it, but a lot of the people who have now been in the market for 10 or 15 years have not really seen that side to it.

Q Talk about the Crash of '87 and the lessons from that.

The Crash of 1987 was a very educational event that, unfortunately, taught the wrong lesson. For one thing, "crash" is really a misnomer. It turned out to be a very violent and explosive correction and the market reversed direction and charged ahead again. So it really turned out to be something of a breather, a very violent breather, but it was more of a correction than a crash. A crash really occurs when you suddenly have a violent downturn in the market that then heralds a long bull market. If people had bought money the day before the 1929 Crash, they would have, within the space of a few days, have lost about 25 percent. People who bought money the day after the 1929 Crash and held on until the bottom of the market in 1932 would have lost much money than people had lost in the crash. The market went down to 41. It almost returned to the original level of the Dow Jones Industrial Average in 1896.

And so I think that the 1987 Crash, and I use the word "crash" in quotes here, taught the misleading lesson that sharp market downturns are invariably buying opportunities and that if you have a little bit of pluck and stamina and patience, the market will shortly turn around and zoom ahead. There are moments in history where you have these very cataclysmic downturns in the market and then they just keep going down.

Q How do you think the modern investor would handle such a situation as the market's continuous plummeting?

Sooner or later we have a sustained bear market. We have not repealed the business cycle. It's unlikely that financial history has turned a corner and that we're in a brand-new world where we will never see manias, panics and crashes again. They've been too much a part of the financial landscape for too many centuries. And one of the reasons that I worry about the institutionalized complacency in market is that once that complacency is shattered, it will turn to fear. It will turn to the most unreasoning kind of fear, which is panic. And the panic becomes proportionate to the complacency. And I think that there are so many people who lived through the 1987 Crash, who now think they know the worst that the stock market has to offer, who are really not psychologically prepared for a market that would go down 30-40 percent over a period of a year or two. I don't know that we will ever have again this sort of situation that we had between the 1929 and 1932, because earlier in the century the little people would enter the stock market in a very sporadic and opportunistic way. They would run in late in rallies when there was a certain amount of euphoria. They would then get burned. They would then run out of the market again. We now have a breadth and depth of involvement of the small investor that is unprecedented when you have 50 million people buying stocks and mutual funds. That's a tremendous base for the stock market. Also even if we had a very violent crash, we'd have a situation now where a lot of stock investment through 401K plans and other retirement plans that are actually written into employment contracts. They're part of collective bargaining agreements. No matter how frightened or disillusioned people became, these systems would continue to go on. And so it's an institutionalized involvement of individuals. Now, admittedly, if we had a bear market where there were outcries from the public that they could not bear the pain of this prolonged market downturn, then over the course of time it would change the way that companies restructure their retirement plans. But it would have to be very severe and very prolonged.

Q What about the idea of turning part of the Social Security Fund into the stock market?

I'm dubious about having Social Security put into the stock market. I think that we have gotten very far away from the idea that there's something sacrosanct about retirement investments and that they should be restricted to things that are very, very safe. One other thing that I find myself worrying about is what would happen if we had a sustained bear market after a lot of the Baby Boomers had retired, they were all past 59, they were beginning to draw from these different retirement plans that were invested in the stock market, and yet suddenly their stocks were under water, on paper their investments were down 30-40-50 percent. What would they do? They would face two options, both options, to my mind, fraught with peril. They could either decide that they would tighten their belts and ride out the storm and reduce their discretionary spending, which would tremendously intensify and prolong any recession. Or they could say, "Well, we have to cash in the stocks because we need the money to live on," in which case they would suffer a permanent, perhaps quite devastating decrease in their retirement funds. We really haven't had very much experience with people funding their retirement out of the stock market, and we don't know, frankly, how it would work under every scenario. And, frankly, I don't see that there are a lot of people who are studying that are even speculating about it.

Q How has the attitude of people changed toward a possible market crash since 1929?

So much of American history has revolved around the distinction between Wall Street and Main Street, which historically always seemed to be locked in this bitter battle. And Main Street versus Wall Street was a kind of short-hand for the clash between ordinary working Americans, who were generally concerned with jobs and growth and paying off their debts, and Wall Street bankers and rich individual, who tended to worry much more about sound currency, containing inflation, and collecting on their debts.

When you have 50 to a hundred million people in the stock market, the distinction between Wall Street and Main Street breaks down and disappears. Main Street is Wall Street now and Wall Street is completely dependent upon Main Street. And so instead of having two opposing world views, you have a single world view.

Wall Street today is Main Street and Main Street is Wall Street. And if you look at both of our political parties, for instance, there is a bipartisan consensus on the importance of fighting inflation and having a strong Federal Reserve Board. Go back to the 1960s and your average Democratic politician was an easy money populist who's constantly haranguing the Federal Reserve Board to lower interest rates and stimulate the economy. You don't hear that now from the Democratic Press. There are tens of millions of people in both parties who are heavily invested in the stock market and who have suddenly discovered the virtues of tight money and a strong Federal Reserve Board.

Q Has that made Americans sympathetic to the idea of downsizing and other corporate things that get the stock price up?

It's very interesting what happens to people when they invest in the stock market, because suddenly they own a piece of Corporate America. Every morning they get up and they look at the price of their stock. After a while, they're following the stock very closely. Pretty soon they're identifying with the stock, they're rooting for the stock. When different political decisions come out of Washington, they immediately think about the impact of that decision on their stock. We've never had so many little people who, because of their involvement in the stock market, identify with Corporate America in this way. And let's say somebody who, before had been a strong environmentalist, suddenly when there's a new environmental regulation issued in Washington that affect their paper company or their chemical company, they think about it differently.

It's very funny to watch what happens when people buy stock because suddenly they have bought a piece of Corporate America. They begin to follow the stock. They avidly watch in the newspaper to see the closing price of the stock. They begin to cheer for the stock. They root for the stock. They begin to look at all decisions out of Washington in terms of their impact on the stock. In other words, small average working Americans identify with Corporate America and begin to see the world through that lens, and maybe somebody who had been a staunch environmentalist before, when an environmental regulation is issued that affects their paper company or their chemical company, they're not as sympathetic as they might have been before. And there's a very good side to this, that I think that the entire American public is getting a terrific education in American business, because one of the very nice things about investing in the stock market that you tend to learn about all different aspects of the economy. It's your window onto a very large world. And it also gives one an understanding of business and it gives one an appreciation of the problems that business leaders face. So that's the good side. The bad side is that I think in certain cases people so identify with corporate interest that we lose a certain healthy conflict in the country, too.

Q Is it an overstatement to say that we've come to the point where we are driving the market?

I think the single biggest force that has been pushing the market up has been the money flowing in through mutual funds because it tends to flow into the market regardless of what happens. And when it's invested in mutual funds, the mutual managers feel obligated to invest the money. So that money goes to work regardless of whether or not there are good buying opportunities or even companies that are worthy of the investment.

The need for a mutual fund manager to invest the money in stocks and nothing but stocks is well illustrated by the case of Jeff Vinik, who was the chief portfolio manager for Fidelity Magellan Fund, a fund that has over $50 billion in assets, a phenomenal amount, actually bigger than the annual budget of New York City. Here was a man who was probably making several million dollars a year to manage these tens of billion dollars of assets. And yet he made the decision to allocate 90 percent of the portfolio to long-term Treasury bonds. It was a controversial decision. Worse than that, it was a wrong decision because he thought the market would go down and, instead, it went up. But what was inconceivable to many investors was not that he had made a mistake investing in the wrong stocks, but that he had not invested the money in stocks. This was considered the worst taboo of all.

Q Your Vinik thought?

What I find very interesting about the mutual funds managers is that here are people who are the new masters of the universe. They're managing billions, or in certain cases tens of billions of dollars, and yet they're subject to this quiet daily tyranny of the numbers. They remind me of Nixon pitiful helpless giants because they have to perform. We can monitor their performance on a daily basis. We can not only monitor their performance on a daily basis, but we can compare it with the performances of other managers. And the mutual fund industry and the small investors are very relentless and very unforgiving if people don't perform. The problem is that all the mutual fund managers, I think, are trapped in this rather deadly vicious circle, that the more successful they are, the more money flows into their mutual fund. The more money that flows into their mutual fund, the more difficult it is for them to beat the market averages or even to match their own past performance.

And I think that we may see future situations like that of Jeff Vinik at the Fidelity Magellan Fund where mutual funds managers, in order to try to match of surpass their own past performance, will try to do very strange and unconventional things because it becomes increasingly difficult to outsmart the averages as your career prospers and your mutual fund grows larger.

Q Do people now think 15-20 percent return on investment is their divine right?

Well, people in the stock market have been making returns on their investment that are extraordinarily high by traditional financial standards, and they tend to think that is the norm. And at some point we will revert to something closer to the historical situation.

I think a lot of investors in recent years have been in a kind of Never-Never Land of investing where it seems very easy to make 15 or 20 percent on their stocks. And these, by historical standards, are extraordinarily high rates of return. The average rate of return on stocks has been more nearly 10 percent. And perhaps when we finally revert to a situation that is closer to the historical norm, people will be quite shocked to see, in retrospect, just how lofty some of these returns were.

Q Just a sense of the size of this bull market?

One of the things that worries me about the Baby Boom Generation using mutual funds as retirement vehicles is that a lot of them have started investing in mutual funds in their 40s and early 50s. If they had started investing when they were in their 20s, they would have had, by retirement, 30 or 40 years of experience. And over 30-40 years, one can safely say that stocks will outperform other assets. It becomes much trickier when one is talking about five or 10 or 20 years. The growth of this bull market has been phenomenal, that in the last five years 80 percent of all the money in mutual funds has come in during the last five years along. So that this has been a tremendous explosion of money going into the markets through mutual funds of a sort that we've never seen before in American financial history.

....This vibrant, booming stock market has been an extraordinary strategic asset for the United States economy. Because of the love affair between the American public and the American stock market, it is possible for entrepreneurs, technological visionaries and inventors of every sort to get financing. There is no country in the world where it's as easy to find venture capital in the stock market as the United States. And that has given a vitality to small business of a sort that you wouldn't find in any other country, because in other countries they would have to go to conservative bankers who might see very little merit in it. So that a lot of the speculative hoopla that we might deplore in the stock market has also been a godsend for a lot of entrepreneurs in the computer field and biotech and in other areas where in other countries they might never have gotten the seed money from the stock market that they've been able to get here. So it really has financed hundreds, maybe thousands, of new companies in recent years. And it's one reason, I think, that the US economy has been as dynamic and innovative as it has, because the stock market has been so receptive to that kind of innovation almost to a fault.

Q Are we better with this system of the great body of middle class American in the market than we were in the old days of the insiders' game?

American corporations used to be controlled by the bankers and a small group of insiders. It was a very closed, undemocratic place, but we have seen during the last 10 or 20 years there's a kind of wild democratization of Corporate America with share ownership dispersed among tens of millions of Americans. I think that this is very healthy in terms of distributing income and power in the society and really subjecting corporate management to the performance expectations and rigors of the stock market. I think that, on balance, it's very healthy. The problem is, of course, that even if there are 50 to a hundred million Americans who are invested in the stock market, there are still tens of millions of Americans who don't own a single stock. And so it is distributing income and power, but within the middle and upper middle income brackets, and it, unfortunately, is a phenomenon that has not in any way filtered down to the lower middle class.

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