How Might Social Security Privatization Impact the Stock Market?

Key Points

• Social Security privatization puts investment decisions into workers' hands.

• A sudden influx of cash pouring into the stock market is likely to drive up prices.

• The market may feel a little topsy-turvy as inexperienced investors decide to sell poorly performing stocks.

Imagine a scenario in which Social Security taxes are withheld from your paychecks, but instead of trusting the government to look after the money for you, an investment account is opened in your name, and you're responsible for how your Social Security savings are invested. That's Social Security privatization.

The pros and cons of privatization have been debated for decades since President George W. Bush first suggested a plan to convert the current Social Security system. Although no one can see the future, here's a peek at how Social Security privatization could affect the stock market.

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Increased demand

While millions of Americans already invest in the stock market with an eye on retirement, removing part of the safety net that is Social Security and making it mandatory for workers to invest on their own is sure to turbo-charge the amount of money flowing into investments.

All that new money will likely lead to increased demand for investment vehicles, particularly stocks. This increased demand will likely drive up prices, especially in the early days, as the market adjusts to the influx.

Reactive investors?

A Gallup Poll shows that 62% of Americans own stock, but that doesn't mean they handle the day-to-day management of their portfolios. For example, a person who owns stock through an employer-sponsored 401(k) may never have made a significant investment decision.

That leaves 38% of Americans not currently invested in the stock market. When you add 38% to those who invest but don't manage their accounts, you have millions of adults with little investor experience. There's nothing wrong with that, as no one is born knowing all there is to know about investing, and everyone must start somewhere.

However, research indicates that new investors are often more emotional and reactive to daily market changes. Rather than set it and forget it, a new investor is more likely to view daily (or hourly) gyrations in the market as more important than they are and make decisions to sell reflecting a lack of experience.

The stock market is inherently volatile, which helps explain why investors like Warren Buffett only purchase stocks they're willing to hold onto for the long term. Fear-driven movements made by less experienced investors may affect the market as a whole.

More market bubbles?

The term market bubble describes a period when price increases are unsupported by underlying facts. When that bubble bursts, prices crash, often causing significant losses for investors.

There are many examples of market bubbles throughout history, but one of the most interesting occurred in 1636 and 1637 in Holland. Dubbed "Tulip Mania," word got around that tulips were a sure thing for investors who wanted to make quick cash. Tulip prices increased by 20-fold between November 1636 and February 1637 thanks to the newfound rush to buy them. By May 1637, prices had plunged by 99%, leaving a lot of disappointed investors.

A bubble occurs when the price of an asset rises well above its actual value or historical norms. Bubbles are often driven by emotion and fear of missing out. For example, if a famous financial guru announced they had earned millions of dollars investing in swampland, chances are many would follow, artificially driving up the cost until it was unsustainable and the bubble bursts.

The more people who enter the stock market, the greater the chances that market bubbles will appear, especially as inexperienced investors get caught up in the excitement.

Again, no one can predict the future. However, it's fair to say that Social Security privatization would dramatically alter the stock market as we know it.

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