2 APPLES or 1 ORANGE

Old habits die hard but fundamental laws kill habits. Many of us love to eat apples but if the prices changed such that we could buy one apple or two oranges, on average we would eat more oranges. This example illustrates the law of substitution.

The law is so fundamental and usually so gradual that we ignore it. Even when there is a violate shift such as the recent run up in the price of oil, we are creatures of habit and it takes us a while to adjust. If the price differential remains in place, the law trumps the habit every time.

Consumers and businesses practice substitution every day. If the price of oil goes up, we consume more coal. Since it takes money and time to build a coal fired electricity plant, the dollars spent on coal versus oil goes through the famous J-curve. In other words, at first, relatively more is spent on oil because we buy almost the same amounts as before but we buy at a higher price. As new coal plants come on line, the relative amount spent on oil goes down.

BUY STOCKS NOT BONDS

Historically, pension plans have been heavily loaded with bonds. A number of popular ideas led to this situation. Theoretically pension funds are withdrawn and spent so the investments should be of short duration. Another thought has been that one could achieve diversification by holding growth stocks in ones taxable accounts and bonds inside retirement accounts. One of the foundations of this thought was that capital gains require lower tax payments than dividends.

A number of laws have been passed that have altered the relative value of stocks and bonds; including changes in tax rates and in pension laws. The market has started to adjust. For example, companies are increasing dividends at a fast pace. Old habits die hard and the adjustment is no where near complete.

The changes in laws are just as fundamental as the changes put in place in the early 80's that brought interest rates down from 21%. The Bush administration has proposed a number of changes that will pass and that will effect the relative value of stocks and bonds. A good example is the proposals to expand the use of the Roth IRA. The traditional pension plan was often totally paid out within 10 years of a persons retirement. A plan with a relatively short-term vision. Roth IRA's are often paid out over 70 years or more! Roth IRA's are a wonderful estate planning tool. More money is being moved to Roth IRA's everyday. The congress is currently entertaining the Bush proposals to expand the accounts and to even allow Roth 401-K's!

The key factor is a result of a trade-off. Traditional retirement accounts are built with pre-tax dollars. Investors are in effect encouraged to make contributions because the government "matches" about 30% of the contribution. The bad news about the old fashion IRA's is that withdrawals are forced and taxable. One can convert ones IRA to a Roth account, pay the current taxes due, leave the investments in the account to accumulate and to compound income tax free and owe no taxes on withdrawals!

If you understand the power of compounding money income tax free then you know how big a deal this can be!

It gets better!

One is allowed to name beneficiaries to ones account. The beneficiary gets the same benefit of receiving withdrawals from the accounts income tax free! Beneficiaries are forced to gradually withdraw the funds but the withdrawals are based on the life expectancy of the beneficiary.

To appreciate the "gift" that is being offered by this law, take a look at a few of the articles posted at "All Things Financial" which is written by JLP a fee only Financial Planner headquarter in Texas.

Link

I have not learned the correct procedure for posting links. If my attempt failed, you can find the articles at allthingsfinancial.blogspot.com.

The bottom line is incredible. One hundred thousand dollars invested in stocks earning 12% becomes 129 million in 60 years. The same account invested in bonds at 6% becomes 3.6 million!

Greenspan testified to congress that our country government needs to give individuals incentives to save. Allowing long-term accounts to grow at stock market rates, income tax free for long periods of time is a huge incentive.

SUPPLY MEETS DEMAND AT A PRICE

The law of substitution is nothing more than a corollary to the law of supply and demand. I hope you can see how laws passed and being passed are increasing the value of stocks relative to bonds.

Note that I did not mention Social Security Reform. The demand for stocks relative to bonds will increase even if Social Security is not reformed. If Social Security is reformed, it is estimated that by 2011 seventy billion more dollars per year will be flowing from bonds into stocks.

Finally, please remember that the stock market discounts or "predicts" future values. Now is the time to shift your investment emphasis from bonds to stocks. If you make the switch, you will soon have the money to buy 2 APPLES instead of 1.