Why Stocks Are a Bargain
Over the long term, which are less risky for the reward they offer -- stocks or bonds?
Full article can be found on : www.kiplinger.com
By James K. Glassman
From Kiplinger's Personal Finance magazine, April 2007
As night follows day, when the stock market rises, I get phone calls from reporters who want me to talk about the book I coauthored in 1999, Dow 36,000. Just as inevitably, these reporters have not read the book and haven't the foggiest idea what it's about. What they want to know is the precise date that the Dow will hit 36,000, which I don't know now and never claimed I did.
But let's dispose of this question as we get on to more important matters.
Assume the future is like the past 80 years and the Dow produces the market's historical rate of return of a little more than 10% annually, including dividends. Also assume that dividend growth will remain at 2%, so the net price rise in the Dow will be 8%. As I write, the Dow is roughly 12,600. At an 8% growth rate, it will hit 36,000 on approximately February 14, 2021. Celebrate with your Valentine.
But Dow 36,000 was about a much more important subject than guessing when a date and a number would coincide. It was about risk. Normally, the riskier something is, the greater the payoff. The book pointed out an anomaly in investing: a situation in which the payoff is far greater even though the risk is about the same.
We examined what economists call the "equity premium puzzle," which is this paradox: Since 1926, a diversified portfolio of stocks has produced a return averaging, after inflation, about 7% a year, including dividends. Over the same period, long-term U.S. Treasury bonds have produced an average return of less than 3% a year, including interest. Stocks are much more profitable than bonds. The payoff is greater, so the risk must be higher, right?
Yet history also shows that, over the long term and after inflation, stocks are not much riskier than bonds. In fact, in his book Stocks for the Long Run, Kiplinger's columnist Jeremy Siegel, of the Wharton School of the University of Pennsylvania, presents 200 years of data in support of this conclusion: "Although it might appear to be riskier to hold stocks than bonds, precisely the opposite is true. The safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds."
In a common professional judgment, Nicholas Barberis, of Yale University, says, "By any standard measure of risk used by economists, stocks do not appear to be that much riskier than bonds." So what's the explanation for the paradox? Why does one asset return more than another -- that is, provide investors with a "premium" -- if the risk is nearly equal? In a paper co-written with Ming Huang, of Cornell University, and Tano Santos, of Columbia University, Barberis points to behavioral psychology as an explanation. Most investors, he says, are averse to losing money and see stocks, at least in the short run, as being more risky. So they demand a premium -- that is, a higher return.
What this means to you is simple: Own stocks for the long run and profit from other people's misconceptions. By long run I mean at least five years and, even better, ten or more. Stocks are far riskier than bonds in the short term, and that risk can't compensate for the higher average returns. Stick with bonds if your timeline is shorter than five years.
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