More Bad News for Retail Investors, Siegel Had It Wrong

As if your typical retail investor didn't already have enough on his mind these days - with the spring stock market rally ending and many "green shoots" now wilting - Wall Street Journal stock market writer extraordinaire Jason Zweig splashes a big bucket of cold water water on all those who believed what "Stocks for the Long Run" author Jeremy Siegel wrote in 1994 about the long-term performance returns of equities versus other asset classes.

Using data assembled by other scholars, Prof. Siegel extended the history of U.S. stock returns all the way back to 1802. He came to two conclusions that became articles of faith to millions of investors: Ever since Thomas Jefferson was in the White House, stocks have generated a "remarkably constant" average return of nearly 7% a year after inflation. (Adding inflation at 3% yields the commonly cited 10% annual stock return.) And, declared Prof. Siegel, "the risks of holding stocks decrease over time."

There is just one problem with tracing stock performance all the way back to 1802: It isn't really valid.

Tell that to your septuagenarian parents who still have a 70 percent allocation to equities in their investment portfolio...

Just don't tell it to a financial adviser - they have enough problems right now.

Prof. Siegel based his early numbers on data first gathered decades ago by two economists, Walter Buckingham Smith and Arthur Harrison Cole.

For the years 1802 through 1820, Profs. Smith and Cole collected prices on three dozen banking, insurance, transportation and other stocks -- but ended up including only seven, all banks, in their stock-market index. Through 1845, they tracked 19 insurance stocks, but rejected 95% of them, adding only one to their index. For 1834 onward, they added a maximum of 27 railroad stocks.

To be a good measure of stock returns, an index should be comprehensive (by including many stocks) and representative (by including the stocks commonly held by investors). The Smith and Cole indexes are neither, as the professors signaled in their 1935 book, "Fluctuations in American Business." They cherry-picked their indexes by throwing out any stock that didn't survive for the whole period, whose share prices were too hard to find or whose returns seemed "inflexible," "erratic," or "non-typical."

There's much more over at the Journal (it's free) and a video too.

Favorite line from the video?

Jason notes, "What history does seem to tell us is ... that ... history doesn't tell us very much".

Comments

[TeresaE:]

My Grandpa taught me three important things:

1. Pray like all you do depends on God, work like your life depends on you.

2. Follow the dollar, whomever stands to gain the most is easy to spot.

3. History is written, and reported, by those that win.

Which explains why my education, way back when, tended to gloss over the destructive and messy parts of US history, like Native American wars and slavery.

All history is written by the winners.

Which makes it dubious, at best.

Nice piece.

Jul 12 10:30 AM

[milkchaser:]

GM is defunct. Should it have been excluded from indexes? Did no one profit from GM those many decades when it turned a profit?

Perhaps there was a "survivor" bias in Siegel's work, but that only diminishes his conclusion -- it does not reverse it. One can lose all one's capital in a year if one makes spectacularly bad investments. I suspect for all the rubber hat and canal stocks, one can find bonds that defaulted, as well. A fair study would examine stocks and bonds that accrued a heavy volume of investment, as blue-chip indexes do.

Zweig also makes a mistake of saying that, since we only have good figures from 1870 on, we only have 4 good 30 year periods in which to examine the performance of stocks vs. bonds. This is wrong. We have 109 30-year periods from 1870 to now, as each successive period contains the last 29 years of the previous period, plus the next full year.

To make things easier to count, I suggest looking for those few periods when bonds outdid stocks.

Jul 12 11:56 AM

[milkchaser:]

TeresaE -- I take your points, but what kind of history teacher could gloss over slavery? Are you saying that they did not teach the Civil War? My experience (40 years ago) was that the Civil War was taught as the thing that ended the abomination of slavery, but the subsequent 80+ years of racism were glossed over. The states' rights argument was equated with racist slavery. It is only now that the issue of states' rights is beginning to re-emerge as legitimate having been separated from the ignominious history of slavery.

Jul 12 11:56 AM

[Ryu Mei Co:]

Thats is why I fired my smith and barney financial advisor.

Jul 12 07:52 PM

[Mark Bern:]

During the 1990s it seemed as though the major US indices were being "updated" significantly more each year than in the past. There seemed to be a competition to determine which was the most "relavent" by including those stocks whose companies were expected to post the greatest growth. Obviously, the Nasdaq was hot until it was not. When the dot com bubble burst, hot turned to cold.

While there may have been a time when those who construct and maintain the indices actually attempted to created and index that formed a representative sample of American equities, I believe that day may have passed. When a single industry is allowed to represent asmuch as 40% of an index in terms of market cap, question the vaidity and usefulness of that index as a representtion of the ecomony taken as a whole. When that happens and the makeup of the index is not adjusted or rebalanced, I wonder as to the managers' intent.

Jul 12 10:31 PM