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"I know of no way of judging of the future but by the past."
Patrick Henry
In 1963, my parents were preparing for the birth of my oldest sister. I was born three years later in 1966. But back in 1963 if someone asked the question of whether stocks or bonds provided the best returns, there was no well documented proof to answer the question one way or another. Many believed that stocks were too risky and that bonds actually provided better returns in the long run.
Thanks in large part to a donation from Merrill Lynch, researchers at the University of Chicago were building a database of securities information (at the "Center for Research in Security Prices" or CRSP) to help answer that and many other questions. At the end of 1963, Lawrence Fisher and James Lorie began releasing information about their soon to be published article titled "Rates of Return on Common Stocks" which documented the performance of stocks over a 35 year span.1 That research offered the first definitive proof that stocks (as a group) provided stronger performance (when you included their dividends, price movement, and other possible outcomes like mergers) than other investments. They concluded that from 1926 to 1960 common stocks listed on the New York Stock Exchange, with reinvestment of the dividends, returned 9%. Savings accounts and mortgage loans tended to earn around 4-6% over the same period, while corporate bonds yields averaged 5-8%.
Researchers continued expanding on the work of Lorie and Fisher over the following decades and Ibbotson Associates was a frequently cited source for returns and statistics on the major investment classes from 1926 onward. Morningstar bought Ibbotson Associates in 2005 and the firm publishes "Stocks, Bond, Bills, and Inflation" annually, which includes commonly referenced data and graphics on the major investment asset classes over the many decades.
Jeremy Siegel went back even further, piecing together research on investments all the way back to 1802, which he documented in his book Stocks for the Long Run. The latest version of Siegel's book was published at the start of 2014 and included data from 1802-2012. Siegel found that U.S. stocks returned 8.1% annually for the full period versus 5.1% for bonds, 4.2% for bills, 2.1% for gold, and 1.4% for the U.S. Dollar.
Total real returns refer to returns net of inflation. Siegel found that stocks’ real return averaged 6.6% annually for the full period versus 3.6% for bonds, 2.7% for bills, 0.7% for gold. One dollar invested in 1802 would have compounded to $19 if invested in the CPI, $86 if invested in gold, $5,379 if invested in bills, $33,922 if invested in bonds, and $13.48 million if invested in U.S. stocks. The return for stocks beyond the return for bonds is called the “equity risk premium,” and it averaged 3%.
Some have questioned some of the older data, for instance Jason Zweig (writing in the Wall Street Journal) expressed reservations about some of the older data and asked in the title of his column "Does Stock-Market Data Really Go Back 200 Years?"2 Professor Siegel's responded "Yes, Stock Data Do Go Back 200 Years."3 Siegel's data from 1802 to 1897 was based on the research of William Schwert, who published a paper in 1991 titled, “Index of U.S. stocks prices from 1802 to 1897.” Siegel also cited a more recent article titled “A New Historical Database for the NYSE 1815 to 1925: Performance and Predictability” by William Goetzmann, Roger Ibbotson, and Liang Peng.4
While Siegel focuses on the U.S. data, other researchers have calculated returns for other countries with public securities markets. The earliest equity market actually dates back to the middle ages in France where shares of a water mill traded around the 1100s. The shares traded until 1946 when the French government nationalized the mill.5 Actually, according to William Goetzmann, a variety of investment opportunities existed as far back as roughly 4,000 years ago, with ancient Mesopotamia having a functioning secondary loan market in personal promissory notes, and there apparently were opportunities for equity-like investments in maritime expeditions.6
While the U.S. stock market is by far the largest as a percentage of the world's value, some countries have actually had stronger real returns (based on some data sources). But's it's important to keep in mind that most stock markets have not performed as well as the U.S. stock market, and some stock markets have closed, creating a similar issue to the survivorship bias discussed in Chapter 11. I’ll discuss those cases and more about international returns in Chapter 19.
Bonds can be valued by discounting future cash flows using a discount rate, and stocks with dividends can be valued similarly by discounting the projected dividends. Historically, stock valuation models were based on the projected dividends discounted back to a current value, but stocks also tend to rise over time, unlike most bonds which pay back their principal at maturity. So stock value estimates can be based on both projected dividends and projected price appreciation.
Of course many stocks don’t pay dividends, so valuations are usually based on projecting the value of the company (divided by the outstanding shares to arrive at a price per share) or other metrics based on earnings or assets. Valuations have also gotten more complex with the more recent prevalence of stock buybacks by companies. Many companies now use excess cash to buy back shares as a substitute for, or in addition to, paying dividends. Buybacks started becoming an important component of stock returns in the 1980s and by 2000 the effect on the return yield was comparable to the dividend yield.7
There are many web sites, books, and other publications that eloquently address the positives of investing in stocks, but it’s also important to clearly and effectively spell out the inherent risks and other considerations. The strong returns from stocks do not come without risk: the long term returns are an average, and over short and mid-term periods, returns can fluctuate significantly.
There is an ongoing debate over whether the risk of owning stocks decreases over time. Historically, the probability of stocks losing money or underperforming bonds has gone down as the holding period gets longer. But Philippe Jorion argued in “The Long-Term Risks of Global Stock Markets Financial Management” there is little risk reduction over time.8 He suggests that diversification among countries is effective though. Zvi Bodie also questioned the conclusion that stocks are safer in the long run in "On The Risks of Stocks in the Long Run" in a 1995 paper.9
My personal experience has been in line with the long-term historical numbers and I can share a specific example that illustrates the long term compounding effect with stocks. I helped my sister Zippora transfer a retirement account from her employer (the New York City Ballet) into a rollover IRA invested in Vanguard Total Stock Market index fund at Vanguard in 1996. The total amount transferred was a little over $27,000. That account has been left untouched to grow until this day with all dividends and distributions reinvested. At the end of 2007 it was worth almost $64,000, but dropped to just over $40,000 at the end of 2008 during the global financial crisis (the market low was in March 2009). But the stock market has more than tripled since then and by December 2019, the account was close to $180,000. So in 23 years it has multiplied by a factor of more than six.
While the historical data makes for a very persuasive argument for investing in stocks, it can also be used to show the volatility and risks inherent in short term investing. There have been many periods when returns for various asset classes have been inconsistent with long term figures. If you have 20 or 30 years to invest and you assume that historical patterns will hold for the next few decades you may want to keep the following facts in mind.
While the returns on stocks have been strong relative to bonds and bills, investors should try to avoid being overconfident in predicting future returns. There is a general tendency for both professional and individual investors to be overly optimistic about future returns, especially following periods of strong returns. Investors should note that many experts recommend making adjustments to some long term historical returns for a better comparison to current and projected returns. Some recommended adjustments include replacing the average historical bill/bond return with the current yield on the appropriate treasury security and adjusting the historical interest rates upward to account for interest rates being pegged at artificially low levels in the 1940's and early 50's. An alternative method of analyzing returns is to start with the treasury security return (the risk-free rate) and add risk premiums for other investments. From this perspective, changes in interest rates affect returns on all other investments.
Some of my favorite quotes about the study and interpretation on historical data include the following.
"those who do not study history are doomed to repeat it."
George Santayana
"Stocks are a safe bet, but only if you stay invested long enough to ride out the corrections."
Peter Lynch, Worth Magazine, December/January 1997
"If you adhere to the dogma that stocks must beat bonds in the long-enough run, there is no P/E level that the market averages out to at which you will take in sail. A Ponzi bubble is ever possible, and given past psychologies of boom and bust, ever-higher P/E ratios become a self-fulfilling prophecy."
Paul Samuelson, "The Long-Term Case for Equities," The Journal of Portfolio Management, Fall 1994.
"If history books were the key to riches, the Forbes 400 would consist of librarians."
Warren Buffett - Berkshire Hathaway Annual Report, 1990, 18.
"Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years."
Warren Buffett
"In the long run we are all dead."
John Maynard Keynes
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