The Professor Speaks

Have you ever looked at one of those graphs that looks like you can’t lose if you buy stocks? Of course you know that you can lose at any given year during the period highlighted, but these graphic illustrations are supposed to help you understand that if you have the intestinal fortitude to hold the volatile asset class of stocks during the ups and downs, you too can climb the mountain and end up with a bunch of money.

Want proof? If you had a great-great grandparent who purchased a dollar worth of US stocks in January, 1802 and you had inherited the position and held it until the end of 2007, you would have $766,854, or an inflation-adjusted annualized return of 6.8%. As a means of comparison, a dollar invested in bonds would get you $1,320, or a 3.5% annualized return. Parenthetically, if your relative bought a dollar piece of gold in 1802, it’s only worth $2.45 today (including the recent run-up) and the US dollar is actually worth -$0.06, or less than a dollar!

I was reminded of all of these numbers after attending a lecture delivered by legendary professor/writer/commentator Jeremy J. Siegel of the Wharton School of the University of Pennsylvania. Professor Siegel wrote the famous investment book Stocks for the Long Run (now in its fourth edition) for ordinary investors, so I wondered how the group of know-it-all investment advisors would respond to him. I am here to report that the Professor can captivate a room of even the most jaded insiders.

It was like attending a master class with Maria Callas. Professor Siegel started with the basics and built from there. Some key points that got the room nodding in unison included a reminder that the current yield of US Treasury bonds is 3.74%, but this is a nominal yield---it is necessary to calculate the real yield, which subtracts the inflation rate, which even at an assumption of 2.5%, would only get you 1.24%, not including the tax liability that you have by owning this asset class. This does not mean that you should never own bonds, but if you do purchase bonds, you should understand how they compare to stocks over a period of time. Professor Siegel noted that from 1926-2007, stocks yielded a real annualized return of 6.7%, and if we assume a similar future performance, then bonds look like a pretty rotten investment next to stocks.

Does this mean that you should only own stocks? Perhaps if you subscribe to this theory, you would trot out the mother of all bull markets--1981-1999, a time period when the annualized return of 13.6% (bonds did pretty well too, earning 8.4%). The bears would encourage the optimists to look at 1966-1981, when the annualized real return of stocks was actually -0.4%--ouch! These two periods are bookmarks, which is why Professor Siegel always comes back to his assumption of 6.7% as a long-term return, which happens to be the annualized return from 1926-2007.

But here is the thing about the Professor—his statistics are absolute, but as I have said many times, investors are human beings and very few have the ability to stay invested in a portfolio comprised of 100% stocks. The Professor’s research may show that a diversified portfolio actually eats into potential returns, but I look at statistics from the real world---it may be that a diversified portfolio will save an investor from himself and prevent an emotional response to market moves. For more of this kind of data, you should read Stocks for the Long Run and Professor Siegel’s newest book, The Future for Investors: Why the Tried and the True triumphs over the Bold and the New.