Efficient Frontier
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William J. Bernstein

Technology and Investing—A Concrete Example

Rain, Steam, and Speed—The Great Western Railroad
Joseph Mallord William Turner, Oil on canvas

The bedrock of this most euphoric and prosperous of equity markets is the belief that technological progress drives stock returns. And viewed through the longest of historical lenses this is almost certainly true. Angus Maddison, in his seminal Monitoring the World Economy 1820-1992, estimates the annualized growth of global per capita GDP at less than 0.1% from Roman times until 1820, increasing to 1% following 1820. The sudden shift in the planet's economic fortune that occurred with the early nineteenth century's technologic burst is one of the pivotal events of human history. For example, as late as 1811 it took goods about 5 weeks to travel from Paris to Lyon, with considerable attendant expense, physical pain, and peril. By 1850 the steam engine made the same journey possible in one or two days, and at a tiny fraction of its former price, discomfort, and risk.

The revolution in communication was even more dramatic. For most of recorded history information traveled as slowly as physical goods. (The Romans briefly had a signaling system that enabled short messages to travel across the continent in a matter of hours, but only in good weather.) With the invention of the telegraph by Cooke and Wheatstone in 1837 instantaneous communication abruptly changed the face of economic, military, and political affairs in ways that can scarcely be comprehended by even our modern technologically jaded sensibilities. It is humbling to realize that the news of Grant's election in 1868 traveled from New York to San Francisco almost as quickly as it would have today.

Arguably the most physically transformative invention occurring at the birth of the modern was not a new discovery at all, but the resurrection of concrete by John Smeaton. This was in fact an ancient invention, lost for over a thousand years with the fall of Rome.

A credible argument can in fact be made that the pace of technological progress has lately been slowing, not accelerating. After all, what scientific discoveries of the past 80 years rank with thermodynamics, electromagnetism, relativity, and quantum mechanics? An intelligent inhabitant of the western world in 1950 would have no trouble understanding the technology of 2000. On the other hand, a citizen from 1800 or 1900 would each have been rendered inchoate by the technologies of 50 years later.

So what does all this have to do with investing? Surprisingly little. Were there a direct relationship between technological innovation and investment results then equity returns in the first half of the 19th century should have been spectacular. Alas, not. From 1801 to 1850 returns in the US market were just 7.40%. And for the period of the most rapid technologic progress, from 1821 to 1840, stocks returned only 4.36%. The 1830s were a perfect example of how finance so often snatches defeat from the jaws of technological victory, with the political pyrotechnics surrounding the expiration of the charter of the Second Bank of the US overshadowing the apogee of human innovative velocity.

The nature of finance in those halcyon days provides a cautionary tale for those who today extrapolate modern information technology into high security returns. What transpired was quite simple. The excitement generated by the canal, railroad, and telegraph in the 19th century made it very easy for entrepreneurs of varying ability and character to raise capital. In financespeak, the "cost of capital" was dramatically lowered for such ventures. And, unfortunately for investors, cost of capital is simply the opposite face of the investment return coin; cheap capital means low returns. The history of railroad and canal investing on both sides of the 19th century Atlantic was one of wildly inflated expectations, fraud, and bankruptcy.

The same occurred in the 1920s with the invention of the aircraft, automobile, and radio. In fact, the very word "radio" became synonymous with the highflying stock of RCA. Although it eventually became a highly successful company, RCA first brought ruin to hundreds of thousands of investors in the early 30s. The Cowles Commission, chartered by congress in the wake of the crash to document stock returns, found that the "radio, phonograph, and musical instruments" stock category returned -4.4% per year for the 13-year period from 1925 to 1937, versus +4.9% per year for all stocks. (I'm indebted to Professor Will Goetzmann of Yale for providing this data.)

Also quite sobering was the experience of the auto industry. By 1929 there were almost 1,000 car manufacturers. Forty years later there were only 3 players of any size. And the most successful of these, Ford, did not go public until the 1950s. While the return on GM was 12.9% per year for 1925-37, the rest of the industry returned -2.9% per year. Of all the new technologies of the era, aircraft generated the least financial excitement, as its profit-making potential was not immediately obvious. Yet it had the best returns of all industry groups for the period, at 9.3% annualized.

Which brings us to the current era. Unless you've just spent the past few years doing missionary work in Chad, you know that internet startup companies receive capital with an enthusiasm and cheapness unparalleled in financial history. Although undoubtedly great business fortunes will be made by some of these companies, there can be no question that the ease of capitalization in this arena engenders an inattention to the parsimony and efficiency necessary for successful human enterprise. Without putting too fine a point on it, the word that comes most easily to mind here is "orgy." And orgies are not a place where productive work is usually done. (If you want to be both entertained by and informed about the internet IPO scene, I highly recommend Michael Lewis' The New New Thing.)

Investing is the most richly paradoxical of all human activities. History shows that it is precisely the promise of unlimited technological progress that proves most corrosive to equity returns.

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