Efficient Frontier
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William J. Bernstein

Siegel quotes Nobel laureate and famous

Only Two Centuries of Data

We tend to think of the modern securities market as a wondrous newfangled machine, but in fact thereís nothing new under the sun: There are nearly continuous records of bond prices in Europe going back to the 13th century, and stock prices have been quoted in France for well over 500 years.

What is new is our knowledge of the long-term returns of stock and bond markets. Not until Alfred Cowles III became interested in the topic in the wake of the 1929 crash was any light shone on the fortunes of capital-markets participants. Whatís truly curious is that the most detailed data comes from the U.S. market. After all, by the year 1792 when the famous agreement was signed under a buttonwood tree in lower Manhattan, there were already well-established bourses in London, Paris, Amsterdam, and the Hanseatic cities. The U.S. was a small and shaky, if glamorous, sideshow whose very existence was in doubt, and its markets were tiny compared to those in Europe. So it comes as a bit of a surprise that the longest and most solid returns series on stocks and bonds date nearly from the Buttonwood Agreement, whereas high-quality European data are almost impossible to come by before 1920.

Letís look at the returns of stocks and bonds in the 19th and 20th centuries. Iíve tabulated them both before and after inflation, mainly from Jeremy Siegelís database.

Before Inflation









After Inflation









Since investors eat real returns, it makes sense to focus on the bottom table. Notice how real stock returns have not changed that much, whereas real bond returns, while giving stocks a run for their money in the 19th century, lagged badly in the 20th century.

Modern investors tend to focus on the 20th century data, showing that stocks return almost 5% more per year than bonds, and ignore the more equivocal message of the 19th century. But it is not at all obvious that the older data are less relevant. Which do we believe? In the famous words of Paul Samuelson, "We have but one sample of history." And that sample contains only two centuries.

Which century we rely on is critical. If we believe the 5% margin of stocks over bonds in the 20th century, then stocks are a nearly riskless investment in the long term, because over long time periods, risk and return are the same. I discuss this phenomenon in "When Risk and Return Become the Same" also in this quarterís issue, but hereís the short version: Stock enthusiasts are fond of pointing out that there are no 30-year periods when stocks returned less than bonds and that stocks are therefore less risky than bonds. But this is simply an artifact of their higher returns. If the 19th century data are relevant, then stocks clearly are riskier than bonds.

Which century is the anomaly: the 19th or 20th? I believe that flesh-and-blood historical analysis usually trumps statistical rigor. Letís transport ourselves 100 years back to the fin de siècle. The most noticeable financial fact of life you observe is that no one seems very concerned about inflation. Since 1800, inflation has actually been negative; a suit, pound of beef, or trip to the neighboring state actually costs less in nominal termsóthe actual number of dollarsóthan it did in 1800! Even the medieval scholar, who may have been aware of the inflationary 13th or early 17th centuries, would reassure us that he could find no evidence of sustained average price rises in excess of one percent per year. After all, in 1900, as throughout almost all of recorded history, hard gold and silver were money.

So, in 1900, the 5% yield on high-quality bonds is awfully attractive. As far as anyone knows, this is a real yield. Stocks? They too yield 5%, but are fraught with risk. You perform a rigorous study of stock dividends over the past 30 years and discover that yields have hardly grown at all!

Assured of the better risk-adjusted expected return of fixed-income vehicles, you purchase your bonds, clip your coupons, and wait for the time machine to reappear and rescue you from the vicissitudes of unbridled capitalism and bad coffee. But it never comes. What does arrive, unfortunately, is the inflation wrought by two world wars, the death of the gold standard, and fiat money (even worse than the Fiat automobile). Suddenly, your bond coupons, which donít appreciate with inflation, arenít worth what you thought theyíd be. After 100 years, the dollar has devalued by 95%, devastating bond returns. Stocks, on the other hand, have weathered the inflationary storm surprisingly well, since corporations were able to increase their revenues by raising prices. Your smarter and luckier cousin, who bought stocks, finds that for every dollar of dividends he collected in 1900 he now collects $70!

The net result of all this is that during the 20th century, bond prices got revalued downward, as investors discovered that they were vulnerable to this new economic scourge, and stock prices were revalued upward, as investors discovered that they were relatively protected from fiat money.

With hindsight we can see that the 5% stock-bond return gap in the 20th century was the result of a totally unexpected inflationary burst produced by the abandonment of hard money. You canít abandon hard money twice, so a repeat is not possible. Though inflation might increase dramatically in the future, resulting in another high stock-bond return gap, itís at least as likely that inflation will remain tame for the foreseeable future, producing nearly equal stock and bond returns. More importantly, we now live in a world where investors have learned to extract an inflation premium from bonds and to expect inflation protection from stocks. This increases expected bond returns and reduces expected stock returns.

Which brings us back, as usual, to the Gordon Equation: The expected return of a stock or bond is equal to its income stream plus its growth. For stocks, this is (in nominal terms) 1.5% + 5% = 6.5%; and for bonds, 6.0% + 0% = 6.0%.

The twentieth century sure was a barn burnerÖ welcome back to the nineteenth.

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