DY 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 instocks. In August of that year, Crowther published Raskob’s ideas in aLadies’ Home Journal article with the audacious title “Everybody Oughtto Be Rich.”In the interview, Raskob claimed that America was on the verge ofa tremendous industrial expansion. He maintained that by putting just$15 per month into good common stocks, investors could expect theirwealth 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 atmosphere1
Speech in Virginia Convention, March 23, 1775.3
Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
4
PART 1 The Verdict of History
of the 1920s bull market. Stocks excited investors, and millions put theirsavings into the market seeking 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. Sevenweeks 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 Industrials stood at 41.22. The market value of the world’s greatest corporations had declined an incredible 89 percent. Millions of investors’ lifesavings were wiped out, and thousands of investors who had borrowedmoney to buy stocks were forced into bankruptcy. America was mired inthe deepest economic depression in its history.Raskob’s advice was ridiculed and denounced for years to come. Itwas said to represent the insanity of those who believed that the marketcould rise forever and the foolishness of those who ignored the tremendous risks inherent in stocks. Senator Arthur Robinson of Indiana publicly held Raskob responsible for the stock crash by urging commonpeople to buy stock at the market peak.2 In 1992, 63 years later, Forbesmagazine warned investors of the overvaluation of stocks in its issueheadlined “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 guaranteedengine of wealth.3Conventional wisdom holds that Raskob’s foolhardy advice epitomizes the mania that periodically overruns Wall Street. But is that verdict fair? The answer is decidedly no. If you calculate the value of theportfolio of an investor who followed Raskob’s advice in 1929, patientlyputting $15 a month into stocks, you find that his accumulation exceeded that of someone who placed the same money in Treasury billsafter less than 4 years! By 1949 his stock portfolio would have accumulated almost $9,000, a return of 7.86 percent, more than double the annual return in bonds. After 30 years the portfolio would have grown toover $60,000, with an annual return rising to 12.72 percent. Althoughthese returns were not as high as Raskob had projected, the total returnof the stock portfolio over 30 years was more than 8 times the accumulation in bonds and more than 9 times that in Treasury bills. Those whonever bought stock, citing the Great Crash as the vindication of their
23
Irving Fisher, The Stock Market Crash and After, New York: Macmillan, 1930, p. xi.“The Crazy Things People Say to Rationalize Stock Prices,” Forbes, April 27, 1992, p. 150.
CHAPTER 1 Stock and Bond Returns Since 1802
5
caution, eventually found themselves far behind investors who had patiently accumulated equity.4The story of 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 lastcentury, accumulations in stocks have always outperformed other financial assets for the patient investor. Even such calamitous events as theGreat 1929 Stock Crash did not negate the superiority of stocks as longterm investments.
FINANCIAL MARKET RETURNS FROM 1802This chapter analyzes the returns on stocks and bonds over long periods oftime in both the United States and other countries. This two-century history is divided into three subperiods. In the first subperiod, from 1802through 1870, the United States made a transition from an agrarian to anindustrialized economy, comparable to the transition that the “emergingmarkets” of Latin America and Asia are making today.5 In the second subperiod, from 1871 through 1925, the United States became the foremost political and economic power in the world.6 The third subperiod, from 1926to the present, contains the 1929 to 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 andhave served as benchmarks for historical returns.7 The story is told in Figure 1-1. It depicts the total return indexes for stocks, long- and short-termbonds, gold, and commodities from 1802 through 2006. Total return meansthat all returns, such as interest and dividends and capital gains, are automatically reinvested in the asset and allowed to accumulate over time.4Raskob succumbed to investors in the 1920s who wanted to get rich quickly by devising a schemeby which investors borrowed $300, adding $200 of personal capital, to invest $500 in stocks. Although in 1929 this was certainly not as good as putting money gradually in the market, even thisplan beat investment in Treasury bills after 20 years.5A brief description of the early stock market is found in Appendix 1 at the end of this chapter. Thestock price data during this period are taken from Schwert (1990), and I have added my own dividend series. G. William Schwert, “Indexes of United States Stock Prices from 1802 to 1987,” Journalof Business, vol. 63 (July 1990), pp. 399–426.6The stock series used in this period are taken from the Cowles indexes as reprinted in RobertShiller, Market Volatility, Cambridge: MIT Press, 1989. The Cowles indexes are capitalizationweighted indexes of all New York Stock Exchange stocks, and they include dividends.7
The data from the third period are taken from the Center for Research in Security Prices (CRSP)capitalization-weighted indexes of all New York stocks, and starting in 1962, they include Americanand Nasdaq stocks.
6
PART 1 The Verdict of History
FIGURE
1–1
Total Nominal Return Indexes, 1802 through December 2006
It can be easily seen that the total return on equities dominates allother assets. Even the cataclysmic stock crash of 1929, which caused ageneration of investors to shun stocks, appears as a mere blip in the stockreturn index. Bear markets, which so frighten investors, pale in the context of the upward thrust of total stock returns. One dollar invested andreinvested in stocks since 1802 would have accumulated to over $12.7million by the end of 2006. This sum can be realized by an investor holding the broadest possible portfolio of stocks in proportion to their marketvalue and is calculated to include those companies that do not survive.8By extension, the above analysis indicates that $1 million investedand reinvested during these more than 200 years would have grown tothe incredible sum of $12.7 trillion by the end of 2006, nearly threequarters the entire capitalization of the U.S. stock market!One million dollars in 1802 is equivalent to roughly $16.84 millionin today’s purchasing power. This was certainly a large, though not8
Analysis of survivorship bias issues in computing returns is discussed in Chapter 20.
CHAPTER 1 Stock and Bond Returns Since 1802
7
overwhelming, sum of money to the industrialists and landholders ofthe early nineteenth century.9 But total wealth in the stock market, or inthe economy for that matter, does not accumulate as fast as the total return index. This is because investors consume most of their dividendsand capital gains, enjoying the fruits of their past saving.It is rare for anyone to accumulate wealth for long periods of timewithout consuming part of his or her return. The longest period of timeinvestors typically hold onto assets without touching the principal andincome occurs when they are accumulating wealth in pension plans fortheir retirement or in insurance policies that are passed on to their heirs.Even those who bequeath fortunes untouched during their lifetimesmust realize that these accumulations are often dissipated in the nextgeneration or spent by the foundations to which the money is bequeathed.10 The stock market has the power to turn a single dollar intomillions by the forbearance of generations—but few will have the patience or desire to endure the wait.
THE LONG-TERM PERFORMANCE OF BONDSBonds 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 bythe terms of the contract. Except in the case of default, bond returns donot vary with the profitability of the firm.The bond series shown in Figure 1-1 are based on long- and shortterm U.S. Treasury bonds, when available; if they were not available,other highest-grade municipal bonds were chosen. Default premiumswere removed from all interest rates in order to obtain a comparable series over the entire period.11The interest rates on long-term bonds and short-term bonds, calledbills, over the 200-year period are displayed in Figure 1-2. Interest ratefluctuations during the nineteenth and early twentieth centuries re9Blodget, an early-nineteenth-century economist, estimated the wealth of the United States at thattime to be nearly $2.5 billion so that $1 million would be only about 0.04 percent of the total wealth:S. Blodget, Jr., Economica, A Statistical Manual for the United States of America, 1806 edition, p. 68.10One of the world’s largest foundations, the Bill and Melinda Gates Foundation to which WarrenBuffett has left the bulk of his money, has announced that all of its money must be spent within 50years of their deaths.11See Jeremy Siegel, “The Real Rate of Interest from 1800–1990: A Study of the U.S. and the U.K.,”Journal of Monetary Economics, vol. 29 (1992), pp. 227–252, for a detailed description of the process bywhich a historical yield series was constructed.
8
PART 1 The Verdict of History
FIGURE
1–2
U.S. Interest Rates, 1800 through December 2006
mained within a narrow range. But from 1926 to the present, the behavior of both long- and short-term interest rates changed dramatically.During the Great Depression of the 1930s, short-term interest rates fellnearly to zero, and yields on long-term government bonds fell to arecord low of 2 percent. In order to finance record wartime borrowings,the government maintained low rates during World War II and the earlypostwar years. Deposit rates were also kept low by strict limits, knownas Regulation Q,12 imposed by the Federal Reserve on bank deposit ratesthrough the 1950s and 1960s.12Regulation Q was a provision in the Banking Act of 1933 that imposed ceilings on interest ratesand time deposits.
CHAPTER 1 Stock and Bond Returns Since 1802
9
The 1970s marked an unprecedented change in interest rate behavior. Inflation reached double-digit levels, and interest rates soared toheights that had not been seen since the debasing of the continental currency in the early years of the republic. Never before had inflation beenso 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 ofinterest rates is closely tied to the level of inflation. Understanding thereturns on fixed-income assets therefore requires knowledge of how inflation is determined.
THE END OF THE GOLD STANDARD AND PRICE STABILITYConsumer prices in the United States and the United Kingdom over thepast 200 years are depicted in Figure 1-3. In each country, the price levelat the end of World War II was essentially the same as it was 150 yearsearlier. But after World War II, the nature of inflation changed dramatically. The price level rose almost continuously during that 60-year period, often gradually, but sometimes at double-digit rates as in the 1970s.Excluding wartime, the 1970s witnessed the first rapid and sustained inflation ever experienced in U.S. history.The dramatic changes in the recent inflationary trend can be easilyexplained. During the nineteenth and early twentieth centuries, theUnited States, United Kingdom, and the rest of the industrialized worldwere on a gold standard. As described in detail in Chapter 11, a goldstandard restricts the supply of money and hence the inflation rate. Butfrom the Great Depression through World War II, the world shifted to apaper money standard. Under a paper money standard there is no legalconstraint on the issuance of money, so inflation is subject to political aswell as economic forces. Price stability depends on the ability of the central banks to limit the growth of the supply of money in order to counteract deficit spending and other inflationary policies implemented bythe federal government.The chronic inflation that the United States and other developedeconomies have experienced since World War II does not mean that thegold standard was superior to the current paper money standard. Thegold standard was abandoned because of its inflexibility in the face ofeconomic crises, particularly during the banking collapse of the 1930s.The paper money standard, if properly administered, can prevent the
10
PART 1 The Verdict of History
FIGURE
1–3
U.S. and U.K. Price Indexes, 1800 through December 2006 (1800 = $1)
banking panics and severe depressions that plagued the gold standardand still bring inflation down to very moderate levels, as we have seenin the last two decades.It is not surprising that the price of gold has closely followed thetrend of overall inflation over the past two centuries. Its price soared to$850 per ounce in January 1980, following the rapid inflation of the preceding decade. When inflation was brought under control, its price fell.One dollar of gold bullion purchased in 1802 was worth $32.84 at theend of 2006. In the long run, gold offers investors protection against inflation, but little else. Whatever hedging property precious metals possess, holding these assets will exert a considerable drag on the return ofa long-term investor’s portfolio.13
CHAPTER 1 Stock and Bond Returns Since 1802
11
TOTAL REAL RETURNSThe focus of every long-term investor should be the growth of purchasing power—that is, 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 andcorrecting them by the changes in the price level shown in Figure 1-3.14The growth of purchasing power in equities not only dominates allother assets but also shows remarkable long-term stability. Despite ex13Ironically, despite the inflationary bias of a paper money system, well-preserved paper moneyfrom the early nineteenth century is worth many times its face value on the collectors’ market, farsurpassing gold bullion as a long-term investment. An old mattress found containing nineteenthcentury paper money is a better find for an antiquarian than an equivalent sum hoarded in gold bars!14Total returns are graphed on a ratio, or logarithmic scale. Economists use this scale to graph virtually all long-term data since equal vertical distances anywhere in the chart represent equal percentage changes in return. As a result, a constant slope represents a constant after-inflation rate of return.
FIGURE
1–4
Total Real Return Indexes, 1802 through December 2006
12
PART 1 The Verdict of History
traordinary changes in the economic, social, and political environmentover 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 bearmarkets that equities have suffered throughout history. The long-termperspective radically changes one’s view of the risk of stocks. The shortterm fluctuations in the stock market, which loom so large to investorswhen they occur, are insignificant when compared to the upward movement of equity values over time.In contrast to the remarkable stability of stock returns, real returnson fixed-income assets have declined markedly over time. In the firstand even second subperiods, the annual returns on bonds and bills, although less than those on equities, were significantly positive. But since1926, and especially since World War II, fixed-income assets have returned little after inflation.
INTERPRETATION OF RETURNSLong-Term ReturnsThe annual returns on U.S. stocks over the past two centuries are summarized in Table 1-1.15 The shaded column represents the real after-inflation, compound annual rate of return on stocks. The real return onequities has averaged 6.8 percent per year over the past 204 years. Thismeans that purchasing power has, on average, doubled in the stock market about every 10 years. If past trends persist—that is, if inflation averages 21⁄2 percent per year and equities offer a 61⁄2 percent forward-lookingannual real return—this increase in purchasing power would translateinto about a 9 percent per year nominal or money return on stocks.Note the extraordinary stability of the real return on stocks over allmajor subperiods: 7.0 percent per year from 1802 through 1870, 6.6 percent from 1871 through 1925, and 6.8 percent per year since 1926. Evensince World War II, during which all the inflation that the United Stateshas experienced over the past 200 years occurred, the average real rate of
15
The dividend yield for the first subperiod has been estimated by statistically fitting the relation oflong-term interest rates to dividend yields in the second subperiod, yielding results that are closer toother information we have about dividends during the period. See Walter Werner and Steven Smith,Wall Street, New York: Columbia University Press, 1991, for a description of some early dividendyields. See also a recent paper by William Goetzmann and Phillipe Jorion, “A Longer Look at Dividend Yields,” Journal of Business, vol. 68, no. 4 (1995), pp. 483–508, and William Goetzmann, “Patternsin Three Centuries of Stock Market Prices,” Journal of Business, vol. 66, no. 2 (1993), pp. 249–270.
CHAPTER 1 Stock and Bond Returns Since 1802
TABLE
13
1–1
Annual Stock Market Returns, 1802 through December 2006
return on stocks has been 6.9 percent per year. This is virtually identicalto the previous 125 years, which saw no overall inflation. This remarkable stability is called the mean reversion of equity returns, which meansthat returns can be very unstable in the short run but very stable in thelong run.Mean reversion can also be seen by noting how the total real returnin stocks “cling” to the statistical trend line fitted through the 204 yearsof stock market data in Figure 1-4. When the total real return on stockswas substantially above the trend line, such as during the late 1960s and1990s, the market was at risk for a correction, as forces of mean reversioneventually worked to bring total returns down. Similarly, periods during which the market fell below the trend line, such as during the early1980s, pointed to promising future returns.The long-term stability of stock returns is all the more surprisingwhen one reflects on the dramatic changes that have taken place in oursociety during the last two centuries. The United States evolved from anagricultural to an industrial economy and then to the postindustrial,service- and technology-oriented economy it is today. The world shiftedfrom a gold-based standard to a paper money standard. And information, which once took weeks to cross the country, can now be instanta-
14
PART 1 The Verdict of History
neously transmitted and simultaneously broadcast around the world.Yet despite mammoth changes in the basic factors generating wealth forshareholders, equity returns have shown an astounding stability.
Short-Term Returns and VolatilityThe bull market from 1982 through 1999 gave investors an extraordinaryafter-inflation return of 13.6 percent per year, which is double the historical average. This constituted the greatest bull market in U.S. stock market history. The superior equity returns over this period followed thedreadful stock returns realized in the previous 15 years, from 1966through 1981, when the real rate of return was –0.4 percent. Nevertheless, this bull market carried stocks too high, as total real returns in Figure 1-4 reached 81 percent above the trend line. The subsequent bearmarket and recovery have brought stocks, as of the end of 2006, neartheir long-term trends.
REAL RETURNS ON FIXED-INCOME ASSETSAs stable as the long-term real returns have been for equities, the samecannot be said of fixed-income assets. The nominal and real returns onboth short-term and long-term bonds are reported in Table 1-2 coveringthe same time periods as in Table 1-1. The real return on bills has droppedprecipitously from 5.1 percent in the early part of the nineteenth centuryto 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 3.7percent in the second, and then to only 2.4 percent in the third. If the returns from the last 80 years were projected into the future, it would take32 years to double one’s purchasing power in bonds and nearly 100years to do so in Treasury bills. In contrast, it takes about 10 years to double purchasing power in stocks.The decline in the average real return on fixed-income securities isstriking. In any 30-year period beginning with 1889, the average real rateof return on short-term government securities has exceeded 2 percentonly three times. Since the late nineteenth century, the real return onbonds 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 oursample. From 1880, the real return on long-term bonds over every 30year period has never reached 4 percent, and it has exceeded 3 percentduring only 22 such periods.
CHAPTER 1 Stock and Bond Returns Since 1802
TABLE
15
1–2
Fixed-Income Returns, 1802 through December 2006
You have to go back more than 11⁄2 centuries to the period from 1831through 1861 to find any 30-year period during which the return on either long- or short-term bonds exceeded that on equities. The dominance of stocks over fixed-income securities is overwhelming forinvestors with long horizons.
THE FALL IN FIXED-INCOME RETURNSAlthough the returns on equities have fully compensated stock investorsfor the increased inflation since World War II, the returns on fixedincome securities have not. The change in the monetary standard fromgold to paper had a far greater impact on the returns of fixed-incomeassets than on stocks. It is clear that the buyers of long-term bonds in the1940s, 1950s, and early 1960s did not recognize the inflationary consequences of the change in monetary regime. How else can you explain
16
PART 1 The Verdict of History
why investors voluntarily purchased 30-year bonds with 3 and 4 percentcoupons ignoring a government policy that favored inflation?But there must have been other reasons for the decline in real returns on fixed-income assets. Theoretically, the unanticipated inflationof the postwar period should have had a significantly smaller effect onthe real return of short-term bonds, such as Treasury bills. This is because short-term rates may be reset frequently to capture expected inflation. But, as noted previously, the decline in the real return on short-termbonds actually exceeded the decline in the real return on long-termbonds.Another explanation for the fall in bond returns is investors’ reaction to the financial turmoil of the Great Depression. The stock collapseof the early 1930s caused a whole generation of investors to shun equities and invest in government bonds and newly insured bank deposits,driving bond returns downward. Finally, many investors bought bondsbecause of the widespread but incorrect predictions that another depression would follow the war.But it was not just the risk preferences of investors that kept fixedrates low. The Federal Reserve actively supported the bond marketthrough much of the 1940s to keep the government’s interest expenselow. This support policy was abandoned in 1951 because it led to interest rates that were inconsistent with one of its primary goals of maintaining low inflation.And finally, one should not ignore the transformation of a highlysegmented market for short-term instruments in the nineteenth centuryinto one of the world’s most liquid markets today. Treasury bills satisfycertain fiduciary and legal requirements that no other asset can match.But the premium paid for these services has translated into a meager return for investors, who have paid a high price for gaining short-term stability of their assets.
THE EQUITY PREMIUMWhatever the reasons for the decline in the real return on fixed-incomeassets over the past century, it is very likely that the real returns onbonds will be higher on average in the future than they have been sincethe end of World War II. As a result of the inflation shock of the 1970s,bondholders have incorporated an inflation premium in the coupon onlong-term bonds. In most major industrialized nations, if inflation doesnot increase appreciably from current levels (2 to 3 percent), real returnsof about 2 percent will be realized from government bonds whose nom-
CHAPTER 1 Stock and Bond Returns Since 1802
17
inal rate is between 4 and 5 percent. These projected real returns arelower than the 31⁄2 percent average compound real return on U.S. longterm government bonds over the past 205 years, but they are not as lowas they were during the postwar period.The excess return for holding equities over short-term bonds isplotted in Figure 1-5, and it is referred to as the equity risk premium, orsimply the equity premium.16 The equity premium, calculated as the difference in 30-year compound annual real returns on stocks and bills, averaged 1.4 percent in the first subperiod, 3.4 percent in the secondsubperiod, and 5.9 percent since 1926.The abnormally high equity premium since 1926 is certainly notsustainable. It is not a coincidence that the highest 30-year average eq16For a rigorous analysis of the equity premium, see Jeremy Siegel and Richard Thaler, “The EquityPremium Puzzle,” Journal of Economic Perspectives, vol. 11, no. 1 (Winter 1997), pp. 191–200, andmore recently, “Perspectives on the Equity Risk Premium,” Financial Analysts Journal, vol. 61, no. 1(November/December 2005), pp. 61–73, reprinted in Rodney N. Sullivan, Bold Thinking on Investment Management, CFA Institute, 2005, pp. 202–217.
FIGURE
1–5
Equity Risk Premium (30-Year Compound Annual Moving Average, 1831 through December 2006)14%
Stock Minus Bond ReturnsStock Minus Bill Returns
12%
10%
8%
6%
4%
2%
0%
-2%1831
1841
1851
1861
1871
1881
1891
1901
1911
1921
1931
1941
1951
1961
1971
1981
1991
2001
18
PART 1 The Verdict of History
uity return occurred in a period marked by very low real returns onbonds. Since firms finance a large part of their capital investment withbonds, the low cost of obtaining such funds increased returns to shareholders. The period of the 1930s and 1940s marked an extremely undervalued period for equities and overvalued period for governmentbonds, leading to unusually high returns for stocks and low returns forbonds. As stocks and bonds become more correctly priced, the equitypremium will certainly shrink. Chapter 8 will further discuss the equitypremium and its implications for future returns.
WORLDWIDE EQUITY AND BOND RETURNS:GLOBAL STOCKS FOR THE LONG RUNWhen I published Stocks for the Long Run in 1994, some economists questioned whether my conclusions, drawn from data from the UnitedStates, might overstate equity returns measured on a worldwide basis.Several economists emphasized the existence of a survivorship biasin international returns, a bias caused by the fact that long-term returnsare intensively studied in successful equity markets, such as the UnitedStates, but ignored in countries, such as Russia or Argentina, wherestocks have faltered or disappeared outright.17 This bias suggested thatstock returns in the United States, a country that over the last 200 yearshas been transformed from a small British colony into the world’s greatest economic power, are unique and historical equity returns in othercountries would be lower.Three U.K. economists subsequently examined the historical stockand bond returns from 16 countries over the past century and put to bedconcerns about survivorship bias. Elroy Dimson and Paul Marsh, professors at the London Business School, and Mike Staunton, director ofthe London Share Price Database, published their research in a book entitled Triumph of the Optimists: 101 Years of Global Investment Returns. Thisbook provides a rigorous yet readable account of worldwide financialmarket returns in 16 separate countries.Despite the major disasters visited on many of these countries, suchas war, hyperinflation, and depressions, all 16 countries offered substantially positive,