From 1976 onward, mutual funds became important as a mechanism for investment and retirement savings, greatly increasing the numbers of Americans who were investors in the stock market.
The idea of pooling money ventured by many people and investing it in a variety of enterprises is not new. A Dutch merchant named Adriaan van Ketwich is usually credited with starting the first mutual fund in 1774. His investment trust Eendragt Maakt Magt (which translates as “unity makes strength”) let investors diversify by investing funds in a variety of foreign government bonds and West Indies plantation mortgages.
In the early days of British and American financial markets, investment trusts existed that had many of the features associated with contemporary mutual funds. Until the end of the 1960’s, however, these were a small part of the investing picture. The trusts were sold by brokers and were front-end loaded with an 8 percent fee that had to be paid at the time of purchase. By the 1960’s, an era of growing prosperity and enthusiasm for stock investors, about 160 mutual funds were extant, with total assets of $17 billion. They survived the stock crash of May, 1962, handily, and when the Dow Jones Industrial Average first hit 1,000 in 1966, they seemed ready to ride the wave of continued growth fueled by “performance investing.”
Although during boom times it is hard to remember, the stock market follows seemingly inexorable cycles. Rising prices and values for securities (a bull market) alternate with drops and troughs in valuation (a bear market). The concept of index funds first evolved during a devastating trough in the period 1973-1974. Wall Street observers had long noted that even portfolios picked by experts often failed to match the aggregate performance of the market indexes. In 1973, Burton G. Malkiel, a Princeton University economist, published a book that was destined to become a classic, A Random Walk Down Wall Street,
Malkiel theorized that although fund managers and analysts work with the best publicly available information, their judgment is flawed because of the “efficient market hypothesis.” Any advantage experts get from new information about a company’s or stock’s prospects is immediately observed by others, who also act on that knowledge, hence boosting (or sinking) that stock’s overall market position compared with others. Malkiel suggested that index funds made up of stocks listed on indexes such as the Standard & Poor’s (S&P) 500 might be a way around this dilemma. His book’s title reflects the fact that the market’s ups and downs are unpredictable because they are influenced by random events.
At this point in the 1970’s only a few index funds existed, designed for pension funds and other institutional investors, but soon a bursting bubble gave rise to a new investment vehicle. John C. Bogle, a scholarship recipient who had worked his way up to the chairmanship of Wellington Management Company, started a new index fund in 1976 called the First Index Investment Trust
The 1970’s were a time of wrenching economic events—including gasoline shortages, rapidly rising prices, and rampant inflation that soared into double digits—and few of the past verities about prudent ways to save and invest seemed valid. After it bottomed out in 1974, the stock market remained stuck in a trough for the rest of the decade. As the long slump of the 1970’s and early 1980’s ground on, stocks seemed outdated as investment vehicles. Investors seeking quick profits turned in other directions: to gold, collectibles, foreign markets and securities, and money-market accounts. On the face of it, any new mutual fund vehicle would have seemed doomed to fail.
The impact of inflation on Americans’ traditional retirement plans threw a different light on index funds, however. The stock market’s long-term growth should more than keep pace with inflation if purchasers would simply follow the advice to “buy and hold.”
In 1974, the U.S. Congress passed the Employment Retirement Income Security Act
This rise was fueled in part by corporate restructuring to cut costs and by new technologies that gave rise to whole new market sectors. Personal computers, for example, became common in the workplace and, by the 1990’s, in homes as well. A new index for technology-related stocks, the NASDAQ Composite,
Alan Greenspan, head of the Council of Economic Advisors under President Gerald R. Ford, was appointed chairman of the Federal Reserve Board in August, 1987, a position in which he would eventually serve five full terms. Greenspan was a brilliant economist, and past events had made him hypersensitive to the dangers of the inflationary cycle. He believed in using the power of the Federal Reserve to raise interest rates to head off inflation and, likewise, to cut them to add liquidity whenever an economic slump threatened. Greenspan was also an enthusiast of Wall Street. After his first meeting with the Federal Reserve Board, he remarked that he found it strange that the stock market had not been mentioned at all, and he set out to remedy that. Greenspan and his policies, along with the successful measures taken by President Bill Clinton’s
By the end of the twentieth century, more than 49 percent of Americans were investors in the stock market. This was largely because of their ownership of 401(k) accounts, IRAs, and similar pension instruments that work on a “defined contribution” basis rather than as “defined benefits.” More and more employers began to offer 401(k) plans because with such plans, except for any promised matching of employees’ contributions, usually on a per-pay-period or quarterly basis, employers have no further obligation to pay a certain level of pension benefits in the future.
A 401(k) plan offers tax benefits to both the employer and employees, and unless the 401(k) is poorly or fraudulently managed, the accumulated value of the stock is likely to keep pace with, or even exceed, inflation over the long run. Certainly, 401(k) investments can go awry—because of poor choices or as a result of actual dishonesty—but regular account statements supplied to 401(k) account owners help to head off such misfires.
With the growth of 401(k) plans and IRAs, the total value of mutual fund holdings rose to a level higher than the amount held outright in individual stocks. No longer were market values determined by wealthy individuals playing their hunches or hot tips; rather, the typical stockholder had become an institutional fund, the selections for which are made by financial professionals or sometimes by a computer program. Such stockholders seldom involve themselves in company policy, leaving that to company officers and (sometimes) the oversight of a board of directors. Given this development, few corporations now operate according to the classic theory of stockholder democracy.
In addition, the massive presence of mutual funds takes some of the volatility out of the business cycle. True, some fund managers enjoy playing the odds, or even against them, as much as any racetrack bettor does, and they usually find purchasers who are also willing to take risks for possible large rewards. On the other end of the continuum are the index funds, whose ups and downs track those of the indexes on which they are based. Their makeup may change as certain stocks are added or dropped, but by and large the major indexes mirror the overall stock market.
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Kazanjian, Kirk. Mutual Fund Investor’s Guide, 2004. Upper Saddle River, N.J.: Prentice Hall, 2004. Reference guide provides basic information on mutual funds and profiles of one hundred top funds. -
Mahar, Maggie. Bull! A History of the Boom, 1982-1999. New York: HarperCollins, 2003. Analyzes the spectacular bull market at the end of the twentieth century. Discusses important events of the boom and the individuals involved. -
Malkiel, Burton G. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. 9th ed. New York: W. W. Norton, 2007. Updated edition of the book that made the case for index funds. Also discusses alternate investment strategies.
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