Investment theory in practice

SUPPOSE that you had invested your wealth in a broadly diversified set of stocks, starting in January 1871, with the dividends being rolled back into your portfolio, and with your portfolio being rebalanced every January to maintain diversification. If you had also paid no taxes and incurred no fees, you would have had 65,004 times your initial investment, as of this past January. By contrast, if you had performed the same experiment with long-term US Treasury bonds, you would have only 41 times your initial wealth. That is the difference between an average annual inflation-adjusted return of 7.3 per cent for stocks and 2.5 per cent for bonds – 4.8 points per year, or what Rajnish Mehra and Edward C Prescott called the “equity premium puzzle”.

Of course, neither of these strategies is possible in real life, since one also must pay commissions and deal with the price pressures of rebalancing one’s portfolio by selling winners and buying losers. Taxes, too, would take a big cut. They would be levied on your interest income from bonds, on your realised capital gains from stocks, and – back when stock buybacks were highly disfavoured – on the dividends that you received. Together, these costs would reduce your real return by perhaps one-third, leaving an equity premium for stocks of around 3.2 percentage points per year. That means a stock-market investor could make twice as much as the bond-market investor in 22 years, on average.

Dunning-Kruger effect

Before Edgar L Smith published Common Stocks as Long-Term Investments in the 1920s, this basic fact about stock and bond investors was not widely known. Most people considered stocks highly “speculative”, because they focused more on the returns from individual stocks and on the high likelihood that any given corporation would fail to maintain its position in the marketplace over time. Betting on individual stocks was best left to gamblers, insiders with special information, or those who truly believed they had special insights into the business cycle. But most retail stock-pickers suffer from the Dunning-Kruger effect (thinking that you are smarter than you really are), which is why their losses have long powered the gains of successful professional equity traders.