Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategiesby Jeremy J. Siegel
In this long awaited and eagerly anticipated update, Jeremy Siegel provides his legendary perspective and guidance to an investment world turned upside down.
- McGraw-Hill School Education Group
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PART 1: THE VERDICT OF HISTORY
STOCK AND BOND RETURNS SINCE 1802
"I know of no way of judging the future but by the past." Patrick Henry, 1775
"EVERYBODY OUGHT TO BE RICH"
In the summer of 1929, a journalist named Samuel Crowther interviewed John J. Raskob, a senior financial executive at General Motors, about how the typical individual could build wealth by investing in stocks. In August of that year, Crowther published Raskob's ideas in a Ladies' Home Journal article with the audacious title, "Everybody Ought to Be Rich."
In the interview, Raskob claimed that America was on the verge of a tremendous industrial expansion. He maintained that by putting just $15 a month into good common stocks, investors could expect their wealth to grow steadily to $80,000 over the next 20 years. Such a return-24 percent per year-was unprecedented, but the prospect of effortlessly amassing a great fortune seemed plausible in the atmosphere of the 1920s bull market. Stocks excited investors, and millions of people put their savings into the market seeking a quick profit.
On September 3, 1929, a few days after Raskob's ideas appeared, the Dow Jones Industrial Average hit a historic high of 381.17. Seven weeks later, stocks crashed. The next 34 months saw the most devastating decline in share values in U.S. history.
On July 8, 1932, when the carnage was finally over, the Dow stood at 41.22. The market value of the world's greatest corporations had declined an incredible 89 percent. Millions of investors' life savings were wiped out, and thousands of investors who borrowed money to buy stocks were forced into bankruptcy. America was mired in the deepest economic depression in its history.
Raskob's advice was ridiculed and denounced for years to come. It was said to represent the insanity of those who believed that the market could rise forever and the foolishness of those who ignored the tremendous risks inherent in stocks. Indiana's Senator Arthur Robinson publicly held Raskob responsible for the stock crash by urging common people to buy stock at the market peak. In 1992, 63 years later, Forbes magazine warned investors of the overvaluation of stocks in its issue headlined, "Popular Delusions and the Madness of Crowds." In a review of the history of market cycles, Forbes fingered Raskob as the "worst offender" of those who viewed the stock market as a guaranteed engine of wealth.
Conventional wisdom holds that Raskob's foolhardy advice epitomizes the mania that periodically overruns Wall Street. However, is this verdict fair? The answer is decidedly no. If you were to calculate the value of the portfolio of an investor who followed Raskob's advice, patiently putting $15 a month into stocks, you would find that his or her accumulation would exceed that of someone who placed the same money in Treasury bills after less than 4 years! After 20 years, his or her stock portfolio would have accumulated to almost $9,000, and after 30 years, over $60,000. Although not as high as Raskob had projected, $60,000 still represents a fantastic 13 percent return on invested capital, far exceeding the returns earned by conservative investors who switched their money to Treasury bonds or bills at the market peak. Those who never bought stock, citing the great crash as the vindication of their caution, eventually found themselves far behind investors who had patiently accumulated equity.
John Raskob's infamous prediction illustrates an important theme in the history of Wall Street. This theme is not the prevalence of foolish optimism at market peaks; rather, it is that over the last century, accumulations in stocks have always outperformed other financial assets for the patient investor. Even such calamitous events as the great stock crash of 1929 did not negate the superiority of stocks as long-term investments.
FINANCIAL MARKET RETURNS FROM 1802
This chapter analyzes the returns on stocks and bonds over long periods of time in both the United States and other countries. This two-century history is divided into three subperiods. In the first subperiod, from 1802 through 1870, the United States made a transition from an agrarian to an industrialized economy, comparable with the "emerging markets" of Latin America and Asia today. In the second subperiod, from 1871 through 1925, the United States became the foremost political and economic power in the world. The third subperiod, from 1926 to the present, contains the 1929-1932 stock collapse, the Great Depression, and the postwar expansion. The data from this period have been analyzed extensively by academics and professional money managers and have served as a benchmark for historical returns.
It can be easily seen that the total return on equities dominates all other assets. Even the cataclysmic stock crash of 1929, which caused a generation of investors to shun stocks, appears as a mere blip in the stock return index. Bear markets, which so frighten investors, pale in the context of the upward thrust of total stock returns. One dollar invested and reinvested in stocks since 1802 would have accumulated to nearly $8.80 million by the end of 2001. This sum can be realized by an investor holding the broadest possible portfolio of stocks in proportion to their market value and does not depend on how many of these companies survive or not.
By extension, the preceding analysis indicates that $1 million invested and reinvested during these 200 years would have grown to the incredible sum of $8.80 trillion by the end of 2001, nearly 70 percent of the entire capitalization of the U.S. stock market!
One million dollars in 1802 is equivalent to roughly $15 million in today's purchasing power. This was certainly a large, though not overwhelming, sum of money to the industrialists and landholders of the early nineteenth century. However, total wealth in the stock market, or in the economy for that matter, does not accumulate as fast as the total return index. This is so because investors consume most of their dividends and capital gains, enjoying the fruits of their past saving.
It is rare for anyone to accumulate wealth for long periods of time without consuming part of his or her return. The longest period of time investors typically plan to hold assets without touching principal and income is when they are accumulating wealth in pension plans for their retirement or in insurance policies that are passed on to their heirs. Even those who bequeath fortunes untouched during their lifetimes must realize that these accumulations often are dissipated in the next generation. The stock market has the power to turn a single dollar into millions by the forbearance of generations-but few will have the patience or desire to let this happen.
HISTORICAL SERIES ON BONDS
Bonds are the most important financial assets competing with stocks. Bonds promise fixed monetary payments over time. In contrast to equity, the cash flows from bonds have a maximum monetary value set by the terms of the contract and, except in the case of default, do not vary with the profitability of the firm.
Reserve on bank deposit rates through the 1950s and 1960s.
The 1970s marked an unprecedented change in interest-rate behavior. Inflation reached double-digit levels, and interest rates soared to heights that had not been seen since the debasing of continental currency in the early years of the republic. Never before had inflation been so high for so long.
The public clamored for government action to slow rising prices. Finally, by 1982, the restrictive monetary policy of Paul Volcker, chairman of the Federal Reserve System since 1979, brought inflation and interest rates down to more moderate levels. One can see that the level of interest rates is closely tied to the level of inflation. Understanding the returns on fixed-income assets therefore requires knowledge of how the price level is determined.
THE PRICE LEVEL AND GOLD
The dramatic changes in the recent inflationary trend should not come as a surprise. During the nineteenth and early twentieth centuries, the United States, the United Kingdom, and the rest of the industrialized world were on a gold standard. As described in detail in Chapter 11, a gold standard restricts the supply of money and hence the inflation rate. From the Great Depression through World War II, however, the world shifted to a paper money standard. Under a paper money standard, there is no legal constraint on the issuance of money, so inflation is subject to political as well as economic forces. Price stability depends on the ability of the central banks to limit the supply of money and control the inflationary policies of the federal governments.
The chronic inflation that the United States and other developed economies have experienced since World War II does not mean that the gold standard was superior to the current paper money standard. The gold standard was abandoned because of its inflexibility in the face of economic crises, particularly the banking collapse of the 1930s. The paper money standard, if administered properly, can avoid the banking panics and severe depressions that plagued the gold standard. However, the cost of this stability is a bias toward chronic inflation.
It is not surprising that the price of gold has followed the trend of overall inflation closely over the past two centuries. The price of gold soared to $850 per ounce in January 1980, following the rapid inflation of the preceding decade. When inflation was brought under control, the price of gold fell. One dollar of gold bullion purchased in 1802 was worth $14.38 at the end of 2001. That is actually less than the change in the overall price level! In the long run, gold offers investors some protection against inflation but little else. Whatever hedging property precious metals possess, these assets will exert a considerable drag on the return of a long-term investor's portfolio.
TOTAL REAL RETURNS
The focus of every long-term investor should be the growth of purchasing power-monetary wealth adjusted for the effect of inflation. Figure 1-4 shows the growth of purchasing power, or total real returns, in the same assets that were graphed in Figure 1-1: stocks, bonds, bills, and gold. These data are constructed by taking the dollar returns and correcting them by the changes in price level shown in Figure 1-3.13
The growth of purchasing power in equities not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social, and political environments over the past two centuries, stocks have yielded between 6.6 and 7.0 percent per year after inflation in all major subperiods.
The wiggles on the stock return line represent the bull and bear markets that equities have suffered throughout history. The long-term perspective radically changes one's view of the risk of stocks. The short-term fluctuations in the stock market, which loom so large to investors when they occur, are insignificant when compared with the upward movement of equity values over time.
In contrast to the remarkable stability of stock returns, real returns on fixed-income assets have declined markedly over time. In the first and even second subperiods, the annual returns on bonds and bills, although less than those on equities, were significantly positive. Since 1926, however, and especially since World War II, fixed-income assets have returned little after inflation.
INTERPRETATION OF RETURNS
Note the extraordinary stability of the real return on stocks over all major subperiods: 7.0 percent per year from 1802 through 1870, 6.6 percent from 1871 through 1925, and 6.9 percent per year since 1926. Even since World War II, during which all the inflation that the United States has experienced over the past 200 years occurred, the average real rate of return on stocks has been 7.1 percent per year. This is virtually identical to the preceding 125 years, which saw no overall inflation. This remarkable stability of long-term real returns is a characteristic of mean reversion, a property of a variable to offset its short-term fluctuations so as to produce far more stable long-term returns.
The long-term stability of these returns is all the more surprising when one reflects on the dramatic changes that have taken place in our society during the last two centuries. The United States evolved from an agricultural to an industrial economy and now to a postindustrial service- and technology-oriented economy. The world shifted from a gold standard to a paper money standard. And information, which once took weeks to cross the country, can now be transmitted instantaneously and broadcast simultaneously around the world. Yet, despite mammoth changes in the basic factors generating wealth for shareholders, equity returns have shown an astounding persistence.
The bull market from 1982 through 1999 gave investors an after-inflation return of 13.6 percent per year, which is nearly double the historical average. However, the superior equity returns over this period have barely compensated investors for the dreadful stock returns realized in the preceding 15 years, from 1966 through 1981, when the real rate of return was -0.4 percent. In fact, during the 15-year period that preceded the current bull market, stock returns were more below their historical average than they have been above their average during the 1982-1999 great bull market run.
The bull market since 1982 has brought stocks back from the extremely undervalued state that they reached at the beginning of the 1980s. Certainly the superior performance of stocks over the last decade is extremely unlikely to persist, but this does not necessarily imply that stock returns over the next decade must be below average in order to offset the bull market from 1982. Chapter 7 will analyze future returns on stocks in light of the great bull market of the past two decades.
REAL RETURNS ON FIXED-INCOME ASSETS
As stable as the long-term real returns have been for equities, the same cannot be said of fixed-income assets. Table 1-2 reports the nominal and real returns on both short- and long-term bonds over the same time periods as in Table 1-1. The real return on bills has dropped precipitously from 5.1 percent in the early part of the nineteenth century to a bare 0.7 percent since 1926, a return only slightly above inflation.
The real return on long-term bonds has shown a similar pattern. Bond returns fell from a generous 4.8 percent in the first subperiod to 3.7 percent in the second and then to only 2.2 percent in the third. If the returns from the last 75 years were projected into the future, it would take nearly 33 years to double one's purchasing power in bonds and over 100 years to do so in Treasury bills in contrast to the 10 years it takes in stocks.
The decline in the average real return on fixed-income securities is striking. In any 30-year period beginning with 1889, the average real rate of return on short-term government securities has exceeded 2 percent only three times. Since the late nineteenth century, the real return on bonds and bills over any 30-year horizon has seldom matched the average return of 4.5 to 5 percent reached during the first 70 years of our sample. From 1880, the real return on long-term bonds over every 30-year period has never reached 4 percent, and it exceeded 3 percent during only 17 such periods.
You have to go back more than 11/2 centuries to the period from 1831 through 1861 to find any 30-year period where the return on either long- or short-term bonds exceeded that on equities. The dominance of stocks over fixed-income securities is overwhelming for investors with long horizons.
THE FALL IN FIXED-INCOME RETURNS
Although the returns on equities have fully compensated stock investors for the increased inflation since World War II, the returns on fixed-income securities have not. The change in the monetary standard from gold to paper had its greatest effect on the returns of fixed-income assets. It is clear that the buyers of long-term bonds in the 1940s, 1950s, and early 1960s did not recognize the inflationary consequences of the change in monetary regime. How else can you explain why investors voluntarily purchased 30-year bonds with 3 and 4 percent coupons, ignoring a government policy that was determined to avoid deflation and in fact favored inflation?
However, there must have been other reasons for the decline in real returns on fixed-income assets. Theoretically, the unanticipated inflation of the postwar period should have had a significantly smaller effect on the real return on short-term bonds such as Treasury bills. This is so because short-term rates may be reset frequently to capture expected inflation. As noted previously, however, the decline in the real return on short-term bonds actually exceeded the decline in the real return on long-term bonds.
Another explanation for the fall in bond returns is investors' reactions to the financial turmoil of the Great Depression. The stock collapse of the early 1930s caused a whole generation of investors to shun equities and invest in government bonds and newly insured bank deposits, driving their return downward. Finally, many investors bought bonds because of the widespread (but incorrect) prediction that another depression would follow the war.
However, it was not just the risk preferences of investors that kept fixed rates low. The Federal Reserve actively supported the bond market through much of the 1940s to keep the government's interest expense low. This support policy was abandoned in 1951 because it led to interest rates that were inconsistent with one of the Fed's primary goals of maintaining low inflation.
And finally, one should not ignore the transformation of a highly segmented market for short-term instruments in the nineteenth century into one of the world's most liquid markets. Treasury bills satisfy certain fiduciary and legal requirements that no other asset can match. The premium paid for these services, however, has translated into a meager return for investors.
Whatever the reasons for the decline in the real return on fixed-income assets over the past century, it is almost certain that the real returns on bonds will be higher on average in the future than they have been over the last 70 years. As a result of the inflation shock of the 1970s, bondholders have incorporated a significant inflation premium in the coupon on long-term bonds. In most major industrialized nations, if inflation does not increase appreciably from current levels, real returns of about 2 to 3 percent will be realized from government bonds whose nominal rate is between 5 and 6 percent. These projected real returns are not much lower than the 31/2 percent average compound real return on U.S. long-term government bonds over the past 200 years. Moreover, they are comparable with the yields of the newly floated inflation-linked bonds issued by the U.S. Treasury in 1997.
The excess return for holding equities over short-term bonds is referred to as the equity risk premium, or simply the equity premium, and is plotted in Figure 1-5.15 The equity premium, calculated as the difference in 30-year compound annual real returns on stocks and bills, averaged 1.9 percent in the first subperiod, 3.4 percent in the second subperiod, and 6.5 percent since 1926.
The abnormally high equity premium since 1926 is certainly not sustainable. It is not a coincidence that the highest 30-year average equity return occurred in a period marked by very low real returns on bonds. Since firms finance a large part of their capital investment with bonds, the low cost of obtaining such funds increased returns to shareholders. The 1930s and 1940s marked an extremely undervalued period for equities and overvalued period for government bonds, leading to unusually high returns for stocks and low returns for bonds. As stocks and bonds become more correctly priced, the equity premium certainly will shrink. Chapter 7 will discuss the equity premium and its implications for future returns in more detail.
Some economists have maintained that the superior returns to equity are a consequence of choosing data from the United States, a country that has been transformed from a small British colony to the world's greatest economic power over the last 200 years. However, equity returns in other countries also have substantially outpaced those on fixed-income assets.
The collapse of Japanese stocks during and after World War II was far greater than occurred in its defeated ally, Germany. In Japan, the breakup of the Zaibatsu industrial cartel, the distribution of its shares to the workers, and the hyperinflation that followed the war caused a 98 percent fall in the real value of equities.
Despite the collapse of the equity market, Japanese stocks regained almost all the ground they lost to the Western countries by the end of the 1980s. From 1948 through 1989, the real return on the Japanese market has exceeded 10.4 percent per year, nearly 50 percent higher than the U.S. market. Even including its recent bear market, Japan's real equity returns since 1926 have been 2.9 percent per year. Moreover, because the yen has appreciated in real terms relative to the dollar, the average annual real-dollar returns in the Japanese market have been 3.15 percent per year. Measured in any currency, the real returns in every one of these major countries from 1926 through 2001 have exceeded the real returns on fixed-income assets in any of these countries.
Despite the fact that World War II resulted in a 90 percent drop in real German equity prices, investors were not wiped out. Those who patiently held equity were rewarded with tremendous returns in the postwar period.19 By 1958, the total returns for German stocks had surpassed its prewar level. In the 12 years from 1948 through 1960, German stocks rose by over 30 percent per year in real terms. Indeed, from 1939, when the Germans invaded Poland, through 1960, the real returns on German stocks nearly matched those in the United States and exceeded those in the United Kingdom. Despite the devastation of the war, the recovery of German markets powerfully attests to the resilience of stocks in the face of seemingly destructive political, social, and economic forces.
Over the long run, the returns on British equities are almost as impressive as those in the American market. In contrast to the U.S. experience, the greatest stock decline in Great Britain occurred in 1973 and 1974, not the early 1930s. In 1973-1974, rampant inflation as well as political and labor turmoil caused the British market to lose over 70 percent of its value. The capitalization of the British market fell to a measly $50 billion. This is less than the market value of many individual Internet stocks during the height of the dot-com mania in 1999-2000 or the yearly profits of the OPEC oil-producing nations, whose increase in oil prices contributed to the decline in share values.
In fact, the OPEC nations could have purchased a controlling interest in every publicly traded British corporation in the 1970s with less than 1 year's oil revenues! It is lucky for the British that they did not. The British market has increased dramatically since the 1974 crash and has outstripped the dollar gains in all other major world markets. Again, these rewards went to those who held onto British stocks through this crisis.
Despite Japan's recent bear market, the postwar rise in Japanese stocks is quite remarkable. The Nikkei Dow Jones Stock Average, patterned after the U.S. Dow Jones Average and containing 225 stocks, was first published on May 16, 1949. The day marked the reopening of the Tokyo Stock Exchange, which had been officially closed since August 1945. On the opening day, the value of the Nikkei was 176.21-virtually identical to the U.S. Dow Jones Industrials at that time. By December 1989, the Nikkei soared to nearly 40,000, more than 15 times that of the Dow. Japan's bear market brought the Nikkei below 10,000 following the terrorist attacks in September 2001, just above the level reached by the American Dow. On February 1, 2002, the Nikkei closed at 9,791, below the Dow for the first time in 45 years.
However, comparing U.S. and Japanese Dow indexes overstates the extent of the Japanese decline. The gain in the Japanese market measured in dollars far exceeds that measured in yen. The yen was set at 360 to the dollar 3 weeks before the opening of the Tokyo Stock Exchange-a rate that was to hold for more than 20 years. Since then, the dollar has fallen to about 130 yen. In dollar terms, therefore, the Nikkei climbed to over 100,000 in 1989 and is currently over 30,000, three times its American counterpart, despite the great bear market that has enveloped Japan in the past decade.
The story for foreign countries remains the same as that of the United States: Stocks dominate bonds over all long-term periods. The postwar hyperinflation, when the yen was devalued from 4 to the dollar to 360 to the dollar, wiped out Japanese bondholders. However, nothing compares with the devastation experienced by German bondholders during the 1922-1923 hyperinflation, when the reichsmark was devalued by more than 10 billion to one. All German fixed-income assets were rendered worthless, yet stocks, which represented claims on real land and capital, weathered the crisis.
Over the past 200 years, the compound annual real return on a diversified portfolio of common stock is nearly 7 percent in the United States and has displayed a remarkable constancy over time. The reasons for the persistence and long-term stability of stock returns are not well understood. Certainly the returns on stocks depend on the quantity and quality of capital, productivity, and the return to risk taking. However, the ability to create value also springs from skillful management, a stable political system that respects property rights, and the capacity to provide value to consumers in a competitive environment. Swings in investor sentiment resulting from political or economic crises can throw stocks off their long-term path, but the fundamental forces producing economic growth enable equities to regain their long-term trend. Perhaps this is why long-term stock returns have displayed such stability despite the radical political, economic, and social changes that have affected the world over the past two centuries.
The superior returns to equity over the past two centuries might be explained by the growing dominance of nations committed to free-market economics. Who might have expected the triumph of market-oriented economies 50 or even 30 years ago? The robustness of world equity prices in recent years might reflect the emergence of the golden age of capitalism-a system in ascendancy today but whose fortunes could decline in the future. Yet, even if capitalism declines, it is unclear which assets, if any, will retain value. In fact, if history is any guide, government bonds in our paper-money world may fare far worse than stocks in any political or economic upheaval. As the next chapter shows, the risks in bonds actually outweigh those in stocks over long horizons.
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