S&P 500 had a total return

But that is known only with hindsight.
With diversification, you have to commit yourself in advance to
the fact that a variety of securities in your portfolio will move in
different directions or at different paces. The simple 50–50 split of
this example is diversification, but you can do a lot more.
The result of diversification is not always a smaller loss. It can
be a smaller gain. In 2003, the year the stock market began its recovery
from the 2000 crash, the S&P 500 had a total return of
28.7 percent while the return for the Russell 2000 was a stunning
47.3 percent. The combined return was 38 percent.

OPEC succeeded

This analysis shows why OPEC succeeded in maintaining a high price of oil
only in the short run. When OPEC countries agreed to reduce their production of
oil, they shifted the supply curve to the left. Even though each OPEC member sold
less oil, the price rose by so much in the short run that OPEC incomes rose. By contrast,
in the long run when supply and demand are more elastic, the same reduction
in supply, measured by the horizontal shift in the supply curve, caused a
smaller increase in the price. Thus, OPEC’s coordinated reduction in supply
proved less profitable in the long run.

Expense of consumers.

When analyzing the effects of farm technology or farm policy, it is important
to keep in mind that what is good for farmers is not necessarily good for society as
a whole. Improvement in farm technology can be bad for farmers who become increasingly
unnecessary, but it is surely good for consumers who pay less for food.
Similarly, a policy aimed at reducing the supply of farm products may raise the incomes
of farmers, but it does so at the expense of consumers.

U.S. farms

A few numbers show the magnitude of this historic change. As recently as
1950, there were 10 million people working on farms in the United States, representing
17 percent of the labor force. In 1998, fewer than 3 million people worked
on farms, or 2 percent of the labor force. This change coincided with tremendous
advances in farm productivity: Despite the 70 percent drop in the number of farmers,
U.S. farms produced more than twice the output of crops and livestock in 1998
as they did in 1950.

limited capacity for production.

In some markets, the elasticity of supply is not constant but varies over the
supply curve. Figure 5-7 shows a typical case for an industry in which firms have
factories with a limited capacity for production. For low levels of quantity supplied,
the elasticity of supply is high, indicating that firms respond substantially to
changes in the price. In this region, firms have capacity for production that is not
being used, such as plants and equipment sitting idle for all or part of the day.
Small increases in price make it profitable for firms to begin using this idle capacity.
As the quantity supplied rises, firms begin to reach capacity. Once capacity is
fully used, increasing production further requires the construction of new plants.
To induce firms to incur thi

Lehman Brothers Yield Index

In the five years through 2006, the Lehman Brothers High-
Yield Index had a compound annual return of 10.2 percent, twice
the return from the Lehman Aggregate portfolio over that period.
Since 1984, the compound annual return for high-yield bonds has
been 9.8 percent, but their risk level is a standard deviation of
12.3, according to Ibbotson Associates, nearly twice that of the
Lehman Aggregate portfolio.

WHAT TO DO

Younger investors should be taking on the most risk. Other investors
should be scaling up their risk level, almost no matter
what age they are.
We are not asking you to walk the risk plank. We are not saying
that you have to take all your money from a safer place and
move it to a riskier place. We do not want you to have nightmares.

Attractive Credits

And if anything happens with inflation it is not likely to be
good. If there is a rise in inflation, say to 4 percent, that will
kill the bond market, sending prices and returns for investors
down. Stocks will be undermined by the higher interest rates,
and rising inflation will make future corporate profits less attractive. If there is a further decline in inflation, deflation becomes
a threat, and the fallout on both stocks and bonds would
be even worse.

The scramble for better returns

The scramble for better returns by taking on more risk has
been under way for a while by many big institutional investors
and mutual fund money managers. And it has already had perverse
results for investors who have been waiting to embrace
their new partner for return. As more and more people take on a
little bit more risk to better their returns, the gain for that added
risk declines for those not on the dance floor.

NASDAQ Composite index

Only the Dow Jones Industrial Average, the narrowest of the
popular stock market barometers, had surpassed its pre-crash
14 YOUR FINANCIAL EDGE
closing high by the end of 2006. The Dow Jones Wilshire 5000
was still 3.3 percent below its all-time high at the end of 2006,
while the S&P 500 stock index was 7.1 percent below its closing
high. The technology-heavy NASDAQ Composite index was a
staggering 52.2 percent below its high.

Slowdown portfolio

That is a portfolio slowdown. Using the 18.5 percent compound
annual total return from 1982 through 1999, that portfolio
invested in stocks would double in size in just over four years.
A 1990s portfolio doubled in less than three years.
Another reason to take more risk is that many investors have
to make do with less. Investor portfolios that were stuffed with
technology and telecommunications stocks have not recovered
from the losses suffered when the bubble popped.

1990s stock bubble.

So what should that be? The compound annual rate of return
for stocks from 1946 through 2006 is 11.5 percent, with the after-
inflation or real return at 7.2 percent. So investors may be
faced not with just half the returns from the 1990s stock bubble,
but less than half.Another reason for thinking stock market returns will be
lower is the valuation of the equity market. Stocks in the closely
watched S&P 500 stock index are still a little expensive historically,
even after the collapse that began in 2000. As of the end of
NEW STEPS 13
TABLE 1.1 Keeping Up with History?
Total Return Total Real Return
1926–2006 10.4% 7.2%
1946–2006 11.5% 7.2%
1946–1965 13.8% 10.7%
1966–1981 6.0% –1.0%
1982–1999 18.5% 14.8%
1995–1999 28.6% 25.6%
1982–2006 13.4% 10.0%
Returning to the historic pace of stock returns means a big decline from the
pace of the 1990s. Total returns and real total returns, adjusted for inflation,
at compound annual rates.
Source: Ibbotson Associates. Data from Standard & Poor’s.
2006, the price-to-earnings ratio for the S&P 500 stock index
was 17.4, according to Standard & Poor’s. That is above the P/E
average of 16.1 since World War II, although it is well below its
peak of 46.5 for 2001.
The P/E ratio on the

Your income and All taxes

The fourth and fifth columns compare the distribution of income and the
distribution of taxes among these five groups. The poorest group earns 4 percent of all income and pays 1 percent of all taxes. The richest group earns 49 percent of all income and pays 59 percent of all taxes.
This table on taxes is a good starting point for understanding the burden of
government, but the picture it offers is incomplete. Although it includes all the
taxes that flow from households to the federal government, it fails to include the
transfer payments, such as Social Security and welfare, that flow from the federal
government back to households. Studies that include both taxes and transfers
show more progressivity. The richest group of families still pays about
one-quarter of its income to the government, even after transfers are subtracted.
By contrast, poor families typically receive more in transfers than they pay in
taxes. The average tax rate of the poorest quintile, rather than being 8.0 percent
as in the table, is a negative 30 percent. In other words, their income is about 30
percent higher than it would be without government taxes and transfers. The
lesson is clear: To understand fully the progressivity of government policies,
one must take account of both what people pay and what they receive.

What is most difficult for investors

This turn of events is most difficult for those investors near or
in retirement. These older investors are traditionally most riskaverse—
and have reason to be. But they will be faced with the
choice of a lower standard of living or taking more risk.

Low inflation makes the return environment

Low inflation makes the return environment for both stocks
and bonds less hopeful even when the economy is in fine shape.
And recessions—yes, there will be more—will undermine corporate
earnings and stock returns even more, while lowering the
yield on all types of bonds. Smaller personal portfolios, savaged
in the bear market that began in 2000, mean returns have to be
higher. And the tampering that is going on with promised corporate
pension benefits means there is less of a cushion for millions
of investors.

THE ABILITY-TO-PAY PRINCIPLE

THE ABILITY-TO-PAY PRINCIPLE
Another way to evaluate the equity of a tax system is called the ability-to-pay
principle, which states that taxes should be levied on a person according to how
well that person can shoulder the burden. This principle is sometimes justified by
the claim that all citizens should make an “equal sacrifice” to support the government.
The magnitude of a person’s sacrifice, however, depends not only on the
size of his tax payment but also on his income and other circumstances. A $1,000
tax paid by a poor person may require a larger sacrifice than a $10,000 tax paid by
a rich one.

Deadweight loss of taxation.

In each of these cases, the quantity of labor supplied responds to the wage (the
price of labor). Thus, the decisions of these workers are distorted when their labor
earnings are taxed. Labor taxes encourage workers to work fewer hours,
second earners to stay at home, the elderly to retire early, and the unscrupulous
to enter the underground economy.
These two views of labor taxation persist to this day. Indeed, whenever you
see two political candidates debating whether the government should provide
more services or reduce the tax burden, keep in mind that part of the disagreement
may rest on different views about the elasticity of labor supply and the
deadweight loss of taxation.

And you need to be increasingly

All of these insights and explanations should help everyday
investors navigate the difficult curves—and the easier straightaways—
on their financial highways. You must not be distracted
from good sense on the straightaways, as millions of investors
were in the late 1990s stock market. And you need to be increasingly
careful on the curves, because they are going to become
sharper and tighter in the years ahead