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own the stock, volume hit 132 million shares, representing $22 billion ofYahoo! stock traded.This story is repeated with virtually every stock added to the index,although the average size of the gain is considerably less than Yahoo!’s.Standard & Poor’s published a study in September 2000 that had determined how adding a stock to an S&P index influenced the price. Thisstudy noted that from the announcement date to the effective date of admission in the S&P 500 Index, shares rose by an average of 8.49 percent.16During the next 10 days following their entrance, these stocks fell by anaverage of 3.23 percent, or about one-third of the preentry gain. Yet oneyear after the announcement, these postentry losses were wiped out,and the average gain of new entrants was 8.98 percent. All these percentages were corrected for movements in the overall market. A more recent study has shown that although the preentry gain has fallen in recentyears, the price of stocks admitted to the S&P 500 still has jumped over 4percent in response to the announcement.17
FUNDAMENTALLY WEIGHTED VERSUS CAPITALIZATION-WEIGHTEDINDEXATIONDespite the overpricing of new entrants into the S&P 500 Index, virtuallyall indexes that have a significant investment following, such as thosecreated by Standard & Poor’s, the Russell Investment Group, or WilshireAssociates, are capitalization weighted. That means that each firm in theindex is weighted by the market value, or the current price times the number of shares outstanding. More recently, most of these indexes adjustthe quantity of shares by subtracting insider holdings, which include largepositions held by insiders and governments from total shares outstanding. Government holdings can be especially large in the emergingeconomies. The number of shares after this adjustment is called floatadjusted shares, where “float” refers to the number of shares that are readily available to buy.18Capitalization-weighted indexes have some very good properties.First, as noted earlier in the chapter, these indexes represent the average16Roger J. Bos, Event Study: Quantifying the Effect of Being Added to an S&P Index, New York: McGrawHill, Standard & Poor’s, September 2000.17See David Blitzer and Srikant Dash, “Index Effect Revisited,” Standard & Poor’s, September 20,2004.18Practically there is no bright line between those shares “readily available” and those that are not.Holdings by index funds may actually be less available than those of close family members.
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dollar-weighted performance of all investors, so that for anyone whodoes better than the index, someone else must do worse. Second, theseportfolios, under certain assumptions, give investors the “best” trade-offbetween risk and return. This means that for any given risk level, thesecapitalization-weighted portfolios give the highest returns, and for anygiven return, these portfolios give the lowest risk. This property is calledmean-variance efficiency.But the assumptions under which this desirable property prevailsare very stringent. Capitalization-weighted portfolios are optimal only ifthe market is efficient in the sense that the price of each stock is an unbiased estimate of the true underlying value of the enterprise. This doesnot mean that the price of each stock is always right; but it does meanthat there is no other easily obtainable information that allows investorsto make a better estimate of its true value. Under efficient markets, if astock goes from $20 to $25 a share, the best estimate of the change in theunderlying value of the enterprise is also 25 percent. There are no factorsunrelated to fundamental value that could have changed the stock price.But, as we learned in Chapter 9, there are many reasons why stockprices change that do not reflect changes in the underlying value of thefirm. Transactions made for liquidity, fiduciary, or tax reasons can impact stock prices, as well as speculators acting on unfounded or exaggerated information. When stock price movements can be caused byfactors unrelated to fundamental changes in firm value, market pricesare “noisy” and are no longer unbiased estimates of true value. I call thisway of looking at the market as the “noisy market hypothesis,” and Ifind it an attractive alternative to the efficient market hypothesis that hasdominated the finance profession over the last 40 years.If the noisy market hypothesis is a better representation of howmarkets work, the capitalization-weighted indexes are no longer thebest portfolios for investors. A better index is a fundamentally weightedindex, in which each stock is weighted by some measure of a firm’s fundamental financial data, such as dividends, earnings, cash flows, andbook value, instead of the market capitalization of its stock.19Fundamentally weighted indexes work in the following manner.Assume earnings are chosen as the measure of firm value. If E representsthe total dollar earnings of the stocks chosen for the index, and Ej is theearnings from a particular firm j, then the weight given to firm j in theindex is Ej/E, its percentage share of total earnings.19
As a matter of full disclosure, I am the senior investment strategy advisor at WisdomTree Investment, Inc., a company that issues fundamentally weighted ETFs.
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For example, the total earnings of all stocks in the S&P 500 Index in2006 were about $735 billion. Google’s earnings came to about $3 billion,so in an earnings-weighted fundamental index, Google would have aweight of 0.41 percent. However, because Google has about twice the PE ratio of the average firm in the S&P 500 Index, its weight in the marketcapitalization-weighted S&P 500 is 0.85 percent, about twice as high.Since Google does not yet pay any dividends, its weight in a dividendweighted fundamental index would be zero.In a capitalization-weighted index, stocks are never sold no matterwhat price they reach. This is because if markets are efficient, the pricerepresents the fundamental value of the firm and no purchase or sale iswarranted.However, in a fundamentally weighted index, if a stock price risesbut the fundamental, such as earnings, does not, then shares are solduntil the value of the stock in the index is brought down to the originallevels. The opposite happens when a stock falls for reasons not related tofundamentals—in this case shares are purchased at the lower price tobring the stock’s value back to the original levels. Making these sales orpurchases is called rebalancing the fundamentally weighted portfolio,and it usually takes place once per year.One of the advantages of fundamentally weighted portfolios is thatthey avoid “bubbles,” those meteoric increases in the prices of stocksthat are not accompanied by increases in dividends, earnings, or otherobjective metrics of firm values. This was certainly the case in 1999 andearly 2000 when the technology and Internet stocks jumped to extraordinary valuations based on the hope that their profits would eventuallyjustify their price. Any fundamentally weighted portfolio would havesold these stocks as their prices rose, while capitalization-weighted indexes continued to hold them because the efficient market hypothesisassumes that all price increases are justified.Note that fundamental indexation does not identify which stocksare over- or undervalued. It is a “passive” index, and the purchases andsales of individual stocks are made according to a predetermined formula. Certainly some overpriced stocks will be bought and some underpriced stocks sold. But it can be shown that if prices are determined bythe noisy market hypothesis, then, on average, a portfolio that buysstocks that go down more than fundamentals and sells stocks that go upmore than fundamentals will boost returns over a capitalizationweighted index and reduce risk.2020
Robert D. Arnott, Jason C. Hsu, and Philip Moore, “Fundamental Indexation,” Financial AnalystJournal vol. 61, no. 2 (March/April 2005). Also Social Science Research Network (SSRN).
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THE HISTORY OF FUNDAMENTALLY WEIGHTED INDEXATIONThe motivation for fundamentally weighted indexation began in the international markets. In the 1980s, when Japan’s stock market was in abubble, many investors with internationally diversified portfolios wereseeking a consistent way to reduce the weight of Japanese stocks. At thattime Morgan Stanley Capital International (MSCI) formulated an international index that weighted each country by GDP rather than marketcapitalization and fortunately reduced the allocation to Japanesestocks.21In 1987 Robert Jones of Goldman Sachs’s quantitative asset management group developed and managed a U.S. stock index in which theweights of each firm in the index were corporate profits. Jones referredto his strategy as “economic investing” because the proportion of eachfirm in the index was related to its economic importance rather its market capitalization.22 Later David Morris, founder and CEO of GlobalWealth Allocation, devised a strategy that combined several fundamental factors into one “wealth” variable.23In 2003, Paul Wood and Richard Evans published research on a fundamentally based approach that evaluated a profit-weighted index ofthe 100 largest companies.24 In early 2005, Robert D. Arnott of ResearchAffiliates, along with Jason Hsu and Philip Moore, published a paper inthe Financial Analyst Journal entitled “Fundamental Indexation” that exposed the flaws of capitalization-weighted indexes and laid the case forfundamentally based strategies.25 In December 2005, the first fundamentally weighted ETF was launched by Powershares to track an index constructed by Research Affiliates based on sales, cash flows, book values,and dividends.26 Six months later, WisdomTree Investments launched 20ETFs based on dividends and followed up in 2007 with six more basedon earnings.2721
Henry Fernandez, “Straight Talk,” Journal of Indexes, July/August 2007.Robert Jones, “Earnings Basis for Weighting Stock Portfolios,” Pensions and Investments, August 6,1990.23To see a complete set of the FTSE/GWA Index rules, go to www.ftse.com/Indices/FTSE_GWA_Index_Series/Downloads/FTSE_GWA_Index_Rules.pdf.24Paul C. Wood and Richard E. Evans, “Fundamental Profit-Based Equity Indexation,” Journal of Indexes, Second Quarter 2003.25Arnott, Hsu, and Moore, “Fundamental Indexation.”26For a full description of the FTSE/RAFI Index methodology, visit www.ftse.com/Indices/FTSE_RAFI_Index_Series/2006Downloads/FTSE_RAFI_Indexrules.pdf.27As a matter of full disclosure, I am the senior investment strategy advisor at WisdomTree Investment, Inc., a company that issues fundamentally weighted ETFs.22
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The historical evidence to support fundamentally weighted indexation is impressive. From 1964 through 2005, the compound annual return on a dividend-weighted index based on virtually all U.S. stocks was11.88 percent per year, 123 basis points above a like capitalizationweighted portfolio based on the same stocks while the volatility andbeta of the dividend-weighted portfolio was less than the capitalizationweighted portfolio. This return outperformance with lower volatilitywas reported across size sectors and internationally. Specifically, from1996 through 2005, a dividend-weighted MSCI EAFE Index outperformed an EAFE Index by nearly 51⁄2 percentage points per year.28The long-term outperformance of fundamentally weighted indexesprincipally relies on their emphasis of value-based strategies. Stocks withhigher-than-average dividend yields or lower-than-average P-E ratiosreceive higher weights in fundamentally weighted indexes than capitalization-weighted indexes. But fundamentally weighted indexes arebetter diversified than portfolios of only value stocks, and historicallythey have had better risk-returns trade-offs. In any case, fundamentally weighted indexes have very attractive characteristics that challenge the supremacy of capitalization-weighted indexes for long-terminvestors.
CONCLUSIONThe past performance of actively managed equity funds is not encouraging. The fees that most funds charge do not provide investors with superior returns and can be a significant drag on wealth accumulation.Furthermore, a good money manager is extremely difficult to identify,for luck plays some role in all successful investment outcomes.When costs are taken into account, most actively managed fundssignificantly lag the benchmark indexes. Index funds, be they capitalization weighted or fundamentally weighted, are an extremely attractiveway to accumulate stocks for long-term investors.But the past success of these capitalization-weighted indexes doesnot mean that they will always remain the best choice for investors. Theenormous popularity of index funds, particularly those tied to the S&P500 Index, cause prices of newly named stocks in the index to jump inprice, a phenomenon that will likely reduce future returns.The development of fundamentally indexed portfolios may offer ananswer to some of the deficiencies of capitalization-weighted indexes.28
More data can be found on the Web site at www.wisdomtree.com.
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This will be especially true if stock prices behave more like the noisy market hypothesis and less like the efficient market hypothesis. If some investors chronically chase the wrong type of stocks, it may indeed bepossible to “beat the market.”
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CHAPTER
STRUCTURING A PORTFOLIOFOR LONG-TERM GROWTH[The] long run is a misleading guide to current affairs. In the longrun we are all dead. Economists set themselves too easy, too useless atask if in tempestuous seasons they can only tell us when the storm islong past, the ocean will be flat.J O H N M AY N A R D K E Y N E S , 1 9 2 4 1
My favorite holding period is forever.WA R R E N B U F F E T T, 1 9 9 4 2
No one can argue with Keynes’s statement that in the long run we are alldead. But a vision of the long run must serve as a guide for action today.Those who keep their focus and perspective during trying times are farmore likely to emerge as successful investors. Knowing that the sea willbe flat after the storm passes is not useless, as Keynes asserted, but enormously comforting.
12
John Maynard Keynes, A Tract on Monetary Reform, London: Macmillan, 1924, p. 80.Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 20, 1994, p. 58.359
Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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PRACTICAL ASPECTS OF INVESTINGTo be a successful long-term investor is easy in principle but difficult inpractice. It is easy in principle because buying and holding a diversifiedportfolio of stocks, forgoing any forecasting ability, is available to all investors, no matter what their intelligence, judgment, or financial status.Yet it is difficult in practice because we are all vulnerable to emotionalforces that can lead us astray. Tales of those who have quickly achievedgreat wealth in the market tempt us to play a game very different fromthat of the long-term investor.Selective memory also pushes us in the wrong direction. Thosewho follow the market closely often exclaim: “I knew that stock (or themarket) was going up! If I had only acted on my judgment, I would havemade a mint!” But hindsight plays tricks on our minds. We forget thedoubts we had when we made the decision not to buy. Hindsight candistort our past experiences and affect our judgment, encouraging us toplay hunches and try to outsmart other investors, who in turn are playing the same game.For most investors, going down this path leads to disastrous results. We take far too many risks, our transactions costs are high, and weoften find ourselves giving into the emotions of the moment—pessimism when the market is down and optimism when the market ishigh. This leads to frustration as our misguided actions result in substantially lower returns than we could have achieved by just staying inthe market.
GUIDES TO SUCCESSFUL INVESTINGAchieving good returns in stocks requires keeping a long-term focusand a disciplined investment strategy. The principles enumerated beloware taken from the research described in this book and enable both newand seasoned investors to better achieve their investing goals.1. Keep your expectations in line with history. Historically stocks havereturned 6.8 percent after inflation over the last two centuries and havesold at an average P-E ratio of about 15.A 6.8 percent annual real return, which includes reinvested dividends, will double the purchasing power of your stock portfolio on average every decade. If inflation stays within the 2 to 3 percent range,nominal stock returns will range between 9 and 10 percent per year,which doubles the money value of your stock portfolio every seven toeight years.
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Despite this excellent long-run record, stock returns are not independent of the level of earnings. In Chapter 7 we learned that the longterm real return on the stock market is approximated by the earningsyield, which is the inverse of the price-to-earnings (or P-E) ratio. A 6.8percent return is consistent with a market that sells at about 15 times estimated earnings.But there is no reason why a 15 P-E ratio will always be the “right”ratio for stock prices. Chapter 8 maintains that there are good economicreasons why the stock market may rise to a higher P-E ratio in the future.The decrease in transactions costs, the ability to diversify internationally,and the greater stability of the macroeconomy may cause investors tobid the price of stocks higher and may lead to a higher justified level ofprices, perhaps at 20 times earnings. If stocks do reach and stay at thatlevel, forward-looking real returns will decline to the lower earningsyield of 5 percent per year after inflation, a return that is still considerably above the yields available on bonds.2. Stock returns are much more stable in the long run than in the shortrun. Over time stocks, in contrast to bonds, compensate investors forhigher inflation. Therefore, as an investor’s horizon becomes longer, alarger fraction of one’s assets should be in equities.The percentage of your portfolio that you should hold in equitiesdepends on individual circumstances. But based on historical data, aninvestor with a long-term horizon should keep an overwhelming portion of his or her financial assets in equities. Chapter 2 showed that overholding periods of 20 years or longer, stocks have both a higher returnand lower risk than standard corporate or government bonds.The only long-term risk-free assets are Treasury inflation-protectedsecurities, or TIPS. In recent years the real yield on these bonds has rangedbetween 2 and 3 percent, which is about 4 percentage points a year belowthe historical returns on stocks. The difference between the returns onstocks and the returns on bonds is called the equity premium, and historically it has favored stocks in all countries where data are available.3. Invest the largest percentage of your stock portfolio in low-cost stockindex funds that span a global portfolio.Chapter 20 showed that the broad-based indexes, such as theWilshire 5000 and the S&P 500 Index, have outperformed nearly two outof three mutual funds since 1971. By matching the market year afteryear, an indexed investor is likely to be near the top of the pack when thelong-term returns are tallied.
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There are many ways in which to match the returns on major stockindexes. The last decade has witnessed the explosive growth of both exchange-traded funds (ETFs) and index mutual funds. Both investmentvehicles closely track their respective indexes, have low turnover, andare very tax efficient. Investors in capitalization-weighted index fundsshould insist on a total annual expense ratio under 0.20 percent.4. Invest at least one-third of your equity portfolio in internationalstocks, currently defined as those not headquartered in the UnitedStates. Stocks in high-growth countries often become overpriced andyield poor returns for investors.Today the United States has less than one-half of the world’s equitycapital, and that fraction is declining rapidly. Owning foreign stocks is amust in today’s global economy. In the future, the geographic location ofthe firm’s headquarters will lose its importance as an investment factor.What, where, and to whom a firm sells its products will dominate a newclassification system.As Chapter 10 explains, traditional risk-return analysis on historicaldata indicates that more than one-third of dollar-based portfolios shouldbe invested in stocks headquartered outside the United States. Despitethe increase in the short-term correlation between country returns, thecase for international investing is persuasive. In all countries studied, thereturn on stocks has handily beaten bonds and fixed-income assets overthe last century. Do not overweight high-growth countries, as the datapresented in Chapter 9 show that investors often overpay for growth.5. Historically, value stocks—those with lower P-E ratios and higher dividend yields—have superior returns and lower risk than growth stocks.Tilt your portfolio toward value by buying passive indexed portfolios ofvalue stocks or, more recently, fundamentally weighted index funds.Chapter 9 demonstrated that stocks with low P-E ratios and highdividend yields have outperformed the market over the past 50 yearsand have done so with lower risk. One reason for this outperformance isthat prices of stocks are often influenced by factors not related to theirtrue value, such as liquidity and tax-motivated transactions, rumorbased speculation, and buying and selling by momentum traders. Inthese circumstances, stocks priced low relative to their fundamentalswill likely offer investors a better risk and return profile.Investors can take advantage of temporary mispricings by buyinglow-cost passively managed portfolios of value stocks or newly developed fundamentally weighted indexes that weight each stock by its share of
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dividends or earnings rather than by its market value. Fundamentallyweighted indexes have had higher returns and lower risks historicallythan capitalization-weighted indexes.6. Finally, establish firm rules to keep your portfolio on track, especiallyif you find yourself giving in to the emotion of the moment. If you areparticularly anxious about the market, sit down and reread the first twochapters of this book.Swings in investor emotion almost always send stock prices beyond their fundamental values. The temptations to buy when everyoneis bullish and sell when everyone is bearish are hard to resist. Since it isso difficult to stand apart from this market sentiment, most investorswho trade frequently have poor returns. Chapter 19 shows how behavioral finance helps investors understand and avoid common psychological pitfalls that cause poor market performance. Chapters 1 and 2 keepinvestors focused on the big picture about risk and return.
IMPLEMENTING THE PLAN AND THE ROLEOF AN INVESTMENT ADVISORI wrote Stocks for the Long Run to spell out what returns could be expected on stocks and bonds and to analyze the major factors influencingthose returns. Many investors will consider this book a “do-it-yourselfguide” to choosing stocks and structuring a portfolio. But knowing theright investments is not the same as implementing the right investmentstrategy. As Peter Bernstein so aptly indicates in his foreword to this edition, there are many pitfalls on the path to successful investing that prevent investors from achieving their intended goals.The first pitfall is trading frequently in an attempt to “beat the market.” Many investors are not satisfied earning a 10 percent annual returnon stocks when they know there are always stocks that will double ortriple in price over the next 12 months. Finding such gems is extremelygratifying, and many dream of buying the next corporate giant in its infancy. But the evidence is overwhelming that such investors suffer poorreturns as transactions costs and bad timing sink returns.Investors who have been burned by picking individual stocks oftenturn to mutual funds in their search for higher returns. But choosing amutual fund poses similar obstacles. “Hot managers” with superior pastperformance replace “hot stocks” as the new strategy to beat the market.As a result, many investors end up playing the same game as they hadwith individual stocks and also suffer below-average returns.
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Those who finally abandon trying to pick the best funds aretempted to pursue an even more difficult strategy. They attempt to beatthe market by timing market cycles. Surprisingly, it is often the best-informed investors who fall into this trap. With the abundance of financialnews, information, and commentary at our beck and call, it is extraordinarily difficult to stay aloof from market opinion. As a result, one’s impulse is to capitulate to fear when the market is plunging or to greedwhen stocks are soaring.Many try to resist this impulse. The intellect may say “Stay thecourse!” but this is not easy to do when one hears so many others—including well-respected “experts”—advising investors to beat a hastyretreat. It is easier to follow what everyone else is doing rather than actindependently. And as John Maynard Keynes aptly stated in The General Theory, “Worldly wisdom teaches that it is better for reputation tofail conventionally than to succeed unconventionally.”3 Standingagainst the crowd is hard because failing by following the advice ofother “experts” is far more acceptable than failing by rejecting the investment consensus.What does all this mean to the reader of this book? Proper investment strategy is as much of a psychological as an intellectual challenge.As with other challenges in life, it is often best to seek professional helpto structure and maintain a well-diversified portfolio. If you should decide to seek help, be sure to select a professional investment advisor whoagrees with the basic principles of diversification and long-term investing that I have espoused in these chapters. It is within the grasp of all toavoid investing pitfalls and reap the generous rewards that are availablein equities.
CONCLUDING COMMENTThe stock market is exciting. Its daily movements dominate the financialpress and mark the flows of billions of dollars of investment capital.But stock markets are far more than the quintessential symbol ofcapitalism or repositories of wealth. Stock markets are now found in virtually every country in the world, be it communist or capitalist. They arethe driving forces behind the allocation of the world’s capital and thefundamental engines of economic growth. They are the key to enriching3John Maynard Keynes, The General Theory of Employment, Interest, and Money, New York: Harcourt,Brace & World, 1965, First Harbinger Edition, p. 158. (The book was originally published in 1936 byMacmillan & Co.)
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the lives of both workers and investors around the globe. The main thesis of this book, that stocks represent the best way to accumulate wealthin the long run, remains as true today as it was when I published the firstedition of Stocks for the Long Run in 1994.
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I N D E X
Note: Page numbers followed by i refer to figures or tables; those followed by n refer to notes; those followedby q refer to quotations.Abbott Labs, 59i, 60iAccounting scandals, 89,234–235Accruals, 108Actual high/low, 296nAdobe, 156The ADP National EmploymentReport, 242–243Afghanistan war, 234Africa, growing market shareof, 178–179Agency costs, 100AIG, 175, 176iAlcoa, 40, 56i, 58Allen, Franklin, 171nAllen, Robert Loring, 78nAlpha, 140nAltria Group, 58, 176i, 177Ameren Corp., 48América Móvil, 177American Brands, 48American Cotton Oil, in DJIA,39i, 47American Growth Fund, 351American Spirits Manufacturing, 48American Stock Exchange,Nasdaq compared with, 43American Sugar, in DJIA, 39i,47American Telephone and Telegraph Co. (AT&T), 56i, 57–58,176i, 177American Tobacco, 47, 59i, 61in DJIA, 39i, 48Amoco, 183Amstar, 47Anchoring, 330Anderson, Anne M., 44n
AOL, 88Aramco, 178Arbitrage, index, 257–258Arbitrageurs, 255, 258Ariel, R. A., 316nArithmetic return, 22Arnott, Robert D., 159n, 355n,356The Art of Contrary Thinking(Neill), 333Asch, Solomon, 323Asian crisis, 88AstraZeneca, 177Atomic bomb, 233AT&T, 56i, 57–58, 176i, 177Authorized participants, 252Automatic Data Processing(ADP), 242–243Babson, Roger, 78Baby Bells, 57–58Baldwin, William, 85nBanerjee, Abhijit V., 325nBank of America, 40, 144, 175,176iBank of China, 175Bank of New York Corp., 2