January 10, 2005  Email this  Print this
 License or reprint this article
OPENING SHOT
Time to Forgive Drkoop.com
by James K. Glassman
Five years ago, economist Kevin Hassett and I wrote a book called Dow 36,000. Maybe you've heard of it. The book made the bestseller lists and won accolades from, among others, the
current chairman of the President's Council of Economic Advisers and the editor in chief of this magazine. For some, however, the book became an object of derision because -- just in case you haven't noticed -- the Dow hasn't actually risen to 36,000 yet.
The risk anomaly
This is a good time to review the case we made in the book -- a case in which Kevin and I still strongly believe. Dow 36,000 was not a prognostication. Sure, the Dow will hit 36,000 and probably, eventually, 360,000. But I don't know exactly when, and I don't believe investing is a game of forecasting what's going to happen tomorrow or next year.
Instead, the book tried to explain how stocks are (and should be) valued by investors. Our conclusion was blunt: Stocks are cheap. They had produced so much cash in the past, and were likely to produce so much cash in the future, that their prices deserved to be considerably higher.
We argued that investors, starting roughly in August 1982, when the Dow stood at just 777, had begun to wake up to the true worth of stocks and would bid prices considerably higher, as they should. Our analysis showed that stocks would be fairly priced when the Dow Jones industrial average hit roughly 36,000.
How long would all this take? "It is impossible to predict," we wrote. Stocks never go straight up. There are detours. But Kevin and I believed then (and continue to believe now) that a dispassionate analysis leads to only one result: Stocks are a far better place than bonds and cash to put the lion's share of your money for the long run. That was the unequivocal message of the book.
Let me walk you through our reasoning. Over the long run, a diversified portfolio of stocks has returned a great deal more than a similar portfolio of bonds. Between 1926 and 2003, Standard & Poor's 500-stock index, a good proxy for the market as a whole, produced an annualized return, after inflation and including dividends, of 7.4%. Long-term U.S. Treasury bonds produced 2.4%. That's a gigantic difference.
A basic rule of finance is that if an asset produces a high return, it carries a high risk. But economists long ago discovered an anomaly with stocks. Although stocks return more than bonds, stocks don't carry much more risk in the long term. When you invest in a Treasury bond, it's a virtual certainty that the U.S. government will return your principal at maturity. Along the way, however, the purchasing power of that money will decline because of inflation.
Jeremy Siegel, an economist at the Wharton School of the University of Pennsylvania and a columnist for this magazine, looked at data on U.S. stocks and bonds going back to 1802. He wrote, in his groundbreaking 1995 book, Stocks for the Long Run, that "the safest long-term investment has clearly been stocks and not bonds." He found, for example, that there has never been a period of 17 years or longer in which stocks did not produce a positive return after inflation. Bonds are another story. Looking at every overlapping 20-year period (that is, 1802-21, 1803-22, and so on), Siegel discovered that the worst period for stocks produced a total return of more than 20% after inflation. Bonds? Minus 60%!
Even in the short and medium term, bonds have proved risky. Long-term Treasuries suffered losses in three of the past ten years, as did stocks. Research by Ibbotson Associates has found that for ten-year periods between 1926 and 2003, a portfolio composed of 90% stocks and 10% long-term Treasury bonds has never lost money, but a 100% bond portfolio has.
Siegel's work highlighted what economists call the "equity premium puzzle." Stocks return more than bonds (that is, a premium), but stocks are no more risky over the long term. What's the explanation?
Academics have fretted over this question for years. In Dow 36,000, we offered a possible answer: Investors were irrationally fearful of stocks. They saw the wild volatility of stocks in the short term and extrapolated that risk to the long term. It was like saying that because it rained for three days straight, it would rain the whole year. In fact, stock investing gets less and less risky the longer you hold on. Investors' irrational fears kept prices low.
1
2 NEXT  |
|
MAGAZINE
