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Arnott: The Biggest Urban Legend In Finance

Arnott: The Biggest Urban Legend In Finance


Stocks ought to produce higher returns than bonds in order for the capital markets to “work.” Otherwise, stockholders would not be paid for the additional risk they take for being lower down the capital structure. It comes as no surprise, therefore, that stockholders have enjoyed outsized returns for their efforts for most—but not all—long time periods.

Ibbotson Associates, whose annual data compendium1 covers U.S. stocks and U.S. bonds since January 1926, shows the S&P 500 Index compounding through December 2010 at an annual rate of 9.9% vs. 5.5% for long-term government bonds, an excess return of 4.4%. This return compounds exponentially with time. A $1,000 U.S. stock investment in 1926 would have ballooned to $3 million by December 2010 vs. $92,000 for an investment in long-term bonds, a 32-fold difference.

Emboldened by the 1980s and 1990s (when stocks compounded at 17.6% and 18.2% per annum, respectively), “Stocks for the Long Run” became the mantra for long-term investing, as well as a best-selling book. This view is now embedded into the psyche of an entire generation of professional and casual investors who ignore the fact that much of those outsized returns were a consequence of soaring valuation multiples and tumbling yields. In this issue we examine historical U.S. equity performance from a larger perspective and find that today’s overwhelming equity bias is built on a shaky foundation, reliant on a short and unrepresentative time period.

Let’s Talk Really Long Term
For those willing to do the homework, longer-term stock and bond data exist for the United States. But that picture isn’t quite as rosy as from 1926–2010; therefore, it doesn’t receive as much attention from Wall Street optimists. From 1802–2010, U.S. stocks generated a 7.9% annual return vs. 5.1% for long-term government bonds.2 Our realized excess return was cut to 2.8%—a one-third reduction—by adding 125 years of capital markets history!

Of course, many observers will declare 19th century data irrelevant. A lot has changed! The survival of the United States was in doubt during the early part of the century (War of 1812) and during the debilitating Civil War of the 1860s. The United States was an “emerging market”! The economy was notably short on global trade and long subsistence agriculture. Furthermore, there were three major wars and four depressions—two were deeper than the Great Depression—between 1800 and 1870, a span when data on market returns were notably thin.

By the following century, the United States and its equity markets enjoyed good fortune. It was not invaded and occupied by a foreign power. It did not suffer a government overthrow… just ask Russian investors their return on capital after the Bolshevik Revolution! As Ben Graham might caution, beware the difference between the loss on capital (a drop in price, from which we can recover) and a loss of capital (100% loss, from which we cannot). Russia’s stock market wasn’t alone in the 20th century as three additional top 15 markets in 1900—Egypt, Argentina, and China—suffered a 100% loss of capital while Germany (twice) and Japan (once) came very close.3

Whether we use 200+ years or 80+ years, how many people are pursuing an investment program of that duration? No one, of course. Even “perpetual” institutions such as university endowments aren’t exempt. As the late economic historian Peter Bernstein commented, “… this kind of long run will exceed the life expectancies of most people mature enough to be invited to join such boards of trustees.”4 Relevant horizons for all “long term” investment programs are significantly shorter—10 years or 20 years, maybe 30.



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