No Guts, No Glory
There are certain things that cannot be adequately explained to a virgin either
by words or pictures. Nor can any description that I might offer here even
approximate what it feels like to lose a real chunk of money that you used to
Fred Schwed, from Where Are the Customers' Yachts?
I'm often asked whether the markets behave rationally. My answer is that it
all depends on your time horizon. Turn on CNBC at 9:31 A.M. any weekday morning
and you're faced with a lunatic asylum described by the Three Stooges. But
stand back a bit and you'll start to see trends and regular occurrences. When
the market is viewed over decades, its behavior is as predictable as a Lakers-
Clippers basketball game. The one thing that stands out above all else is the
relationship between return and risk. Assets with higher returns invariably
carry with them stomach-churning risk, while safe assets almost always have
lower returns. The best way to illustrate the critical relationship between risk
and return is by surveying stock and bond markets through the centuries.
The Fairy Tale
When I was a child back in the fifties, I treasured my monthly trips to the
barbershop. I'd pay my quarter, jump into the huge chair, and for 15 minutes
become an honorary member of adult male society. Conversation generally revolved
around the emanations from the television set: a small household god dwarfed by
its oversized mahogany frame. The fare reflected the innocence of the era: I
Love Lucy, game shows, and, if we were especially lucky, afternoon baseball. But
I do not ever recall hearing one conversation or program that included finance.
The stock market, economy, machinations of the Fed, or even government
expenditures did not infiltrate our barbershop world.
Today we live in a sea of financial information, with waves of stock information
constantly bombarding us. On days when the markets are particularly active, our
day-to-day routines are saturated with news stories and personal conversations
concerning the whys and wherefores of security prices. Even on quiet days, it is
impossible to escape the ubiquitous stock ticker scrolling across the bottom of
the television screen or commercials featuring British royalty discoursing
knowledgeably about equity ratios.
It has become a commonplace that stocks are the best long-term investment for
the average citizen. At one time or another, most of us have seen a plot of
capital wealth looking something like Figure 1-1, demonstrating that $1 invested
in the U.S. stock market in 1790 would have grown to more than $23 million by
the year 2000.
Unfortunately, for a number of reasons, no person, family, or organization ever
obtained these returns. First, we invest now so that we may spend later. In
fact, this is the essence of investing: the forbearance of immediate spending in
exchange for future income. Because of the mathematics of compound interest,
spending even a tiny fraction on a regular basis devastates final wealth over
the long haul. During the last two hundred years, each 1% spent each year
reduces the final amount by a factor of eight. For example, a 1% reduction in
return would have reduced the final amount from $23 million to about $3 million
and a 2% reduction to about $400,000. Few investors have the patience to leave
the fruits of their labor untouched. And even if they did, their spendthrift
heirs would likely make fast work of their fortune.
But even allowing for this, Figure 1-1 is still highly deceptive. For starters,
it ignores commissions and taxes, which would have shrunk returns by another
percent or two, reducing a potential $23 million fortune to the above $3 million
or $400,000. Even more importantly, it ignores "survivorship bias." This
term refers to the fact that only the best outcomes make it into the history
books; those financial markets that failed do not. It is no accident that
investors focus on the immense wealth generated by the economy and markets of
the United States these past two centuries; the champion—our stock market—is
the most easily visible, while less successful assets fade quickly from view.
And yet the global investor in 1790 would have been hard pressed to pick out the
United States as a success story. At its birth, our nation was a financial
basket case. And its history over the next century hardly inspired confidence,
with an unstable banking structure, rampant speculation, and the Civil War. The
nineteenth century culminated in the near bankruptcy of the U.S. Treasury, which
was narrowly averted only through the organizational talents of J.P. Morgan.
Worse still, for most of the past 200 years, stocks were inaccessible to the
average person. Before about 1925, it was virtually impossible for even the
wealthiest Americans to purchase shares in an honest and efficient manner.
Worst of all, in the year 2002, the good news about historically high stock
returns is out of the bag. For historical reasons, many financial scholars
undertake the serious study of U.S. stock returns with data beginning in 1871.
But it's worth remembering that 1871 was only six years after the end of the
Civil War, with industrial stocks selling at ridiculously low prices—just
three to four times their annual earnings. Stocks today are selling at nearly
ten times that valuation, making it unlikely that we will witness a repeat of
the returns seen in the past 130 years.
Finally, there is the small matter of risk. Figure 1-1 is also deceptive because
of the manner in which the data are displayed, with an enormous range of dollar
values compressed into its vertical scale. The Great Depression, during which
stocks lost more than 80% of their value, is just barely visible. Likewise, the
1973—1974 bear market, during which stocks lost more than one-half of their
after-inflation value, is seen only as a slight flattening of the plot. And the
October 1987 market crash is not visible at all. All three of these events drove
millions of investors permanently out of the stock market. For a generation
after the 1929 crash, the overwhelming majority of the investing public shunned
The popular conceit of every bull market is that the public has bought into the
value of long-term investing and will never sell their stocks simply because of
market fluctuation. And time after time, the investing public loses heart after
the inevitable punishing declines that stock markets periodically dish out, and
the cycle begins anew.
With that in mind, we'll plumb the history of stock and bond returns around
the globe for clues regarding how to capture some of their rewards.
Ultimately, this book is about the building of investment portfolios that are
both prudent and efficient. The construction of a house is a valuable metaphor
for this process. The very first thing the wise homebuilder does, before drawing
up blueprints, digging a foundation, or ordering appliances, is learn about the
construction materials available.
In the case of investing, these materials are stocks and bonds, and it is
impossible to spend too much time studying them. We will expend a lot of energy
on the several-hundred-year sweep of human investing—a topic that some may
initially find tangential to our ultimate goal. Rest assured that our efforts in
this area will be well rewarded. For the better we understand the nature,
behavior, and history of our building materials, the stronger our house will be.
The study of financial history is an essential part of every investor's
education. It is not possible to precisely predict the future, but a knowledge
of the past often allows us to identify financial risk in the here and now.
Returns are uncertain. But risks, at least, can be controlled. We tend to think
of the stock and bond markets as relatively recent historical phenomena, but, in
fact, there have been credit markets since human civilization first took root in
the Fertile Crescent. And governments have been issuing bonds for several
hundred years. More importantly, after they were issued, these bonds then
fluctuated in price according to economic, political, and military conditions,
just as they do today.
Nowhere is historian George Santayana's famous dictum, "Those who cannot
remember the past are condemned to repeat it," more applicable than in
finance. Financial history provides us with invaluable wisdom about the nature
of the capital markets and of returns on securities. Intelligent investors
ignore this record at their peril.
Risk and Return Throughout the Centuries
Even before money first appeared in the form of small pellets of silver 5,000
years ago, there have been credit markets. It is likely that for thousands of
years of prehistory, loans of grain and cattle were made at interest; a bushel
or calf lent in winter would be repaid twice over at harvest time. Such
practices are still widespread in primitive societies. (When gold and silver
first appeared as money, they were valued according to head of cattle, not the
other way around.) But the invention of money magnified the prime question that
has echoed down through investment history: How much return should be paid by
the borrowers of capital to its lenders?
You may be wondering by now about why we're spending time on the early history
of the credit markets. The reason for their relevance is simple. Two Nobel
Prize-winning economists, Franco Modigliani and Merton Miller, realized more
than four decades ago that the aggregate cost of and return on capital, adjusted
for risk, are the same, regardless of whether stocks or bonds are employed. In
other words, had the ancients used stock issuance instead of debt to finance
their businesses, the rate of return to investors would have been the same. So
we are looking at a reasonable portrait of investment return over the millennia.
The history of ancient credit markets is fairly extensive. In fact, much of the
earliest historical record from the Fertile Crescent—Sumeria, Babylon, and
Assyria—concerns itself with the loaning of money. Much of Hammurabi's
famous Babylonian Code—the first comprehensive set of laws—dealt with
A small ancient example will suffice. In Greece, a common business was that of
the "bottomry loan," which was made against a maritime shipment and
forfeited if the vessel sank. A fair amount of data is available on such loans,
with rates of 22.5% for a round-trip voyage to the Bosphorus in peacetime and
30% in wartime. Since it is likely that fewer than 10% of ships were lost, these
were highly profitable in the aggregate, though quite risky on a case-by-case
basis. This is one of the first historical demonstrations of the relationship
between risk and return: The 22.5% rate of interest was high, even for that
period, reflecting the uncertainty of dealing with maritime navigation and
trade. Further, the rate increased during wartime to compensate for the higher
risk of cargo loss.
Another thing we learn from a brief tour of ancient finance is that interest
rates responded to the stability of the society; in uncertain times, returns
were higher because there was less sense of public trust and of societal
permanence. All of the major ancient civilizations demonstrated a "U-shaped"
pattern of interest rates, with high rates early in their history that slowly
fell as the civilizations matured and stabilized, reaching the lowest point at
the height of the civilizations' development and rising again as they decayed.
For example, the apex of the Roman Empire in the first and second century A.D.
saw interest rates as low as 4%.
As a general rule, the historical record suggests excellent investment returns
in the ancient world. But this record reflects only those societies that
survived and prospered, since successful societies are much more likely to leave
a record. Babylonian, Greek, and Roman investors did much better than those in
the nations they vanquished—the citizens of Judea or Carthage had far bigger
worries than their failing financial portfolios.
This is not a trivial issue. At a very early stage in history we are
encountering "survivorship bias"—the fact that only the best results tend
to show up in the history books. In the twentieth century, for example,
investors in the U.S., Canada, Sweden, and Switzerland did handsomely because
they went largely untouched by the military and political disasters that befell
most of the rest of the planet. Investors in tumultuous Germany, Japan,
Argentina, and India were not so lucky; they obtained far smaller rewards.
Thus, it is highly misleading to rely on the investment performance of
history's most successful nations and empires as indicative of your own future
At first glance, it might appear that the above list of winners and losers
contradicts the relationship between risk and return. This is an excellent
example of "hindsight bias"; in 1913 it was by no means obvious that the
U.S., Canada, Sweden, and Switzerland would have the highest returns, and that
Germany, Japan, Argentina, and India, the lowest. Going back further, in 1650
France and Spain were the mightiest economic and military powers in Europe, and
England an impoverished upstart torn by civil war.
The interest rate bottom of 4% reached in Rome is particularly relevant to the
modern audience. Never before, and perhaps not since, have the citizens of any
nation had the sense of cultural and political permanence experienced in Rome at
its apex. So the 4% return at Rome's height may represent a kind of natural
lower limit of investment returns, experienced only by the most confident (or
perhaps overconfident) nations at the top of their game.
The Austrian economist Eugen von Böhm-Bawerk stated that the cultural and
political level of a nation could be discerned by its interest rate: The more
advanced the nation, the lower the loan rate. Economist Richard Sylla notes that
a plot of interest rates can be thought of as a nation's "fever chart,"
with upward spikes almost always representing a military, economic, or political
crisis, and long, flat stretches signifying extended periods of stability.
As we'll see, the 4% Roman rate of return is about the same as the aggregate
return on capital (when stocks and bonds are considered together) in the U.S. in
the twentieth century, and perhaps even a bit more than the aggregate return
expected in the next century. (The 4% Roman rate was gold-based, so the return
was a real, that is, after-inflation, return.)
The same phenomenon was observed in Europe. The primitive and unstable societies
of medieval Europe initially had very high interest rates, which gradually fell
as the Dark Ages gave way to the Renaissance and Enlightenment. To illustrate
this point, Figure 1-2 shows European interest rates from the thirteenth through
the eighteenth centuries.
One of the most important European financial inventions was the "annuity,"
that is, a bond that pays interest forever, without ever repaying the principal
amount. This is different from the modern insurance company annuity, in which
payments cease with the death of the owner. European annuities were usually
issued by a government to pay for war expenses and never expired; instead, they
were handed down and traded among succeeding generations of investors. Newcomers
tend to recoil at a loan that yields only interest with no return of principal,
but the annuity provides a very useful way of thinking about the price of a loan
or bond. It's worth spending some time discussing this topic, because it forms
one of the foundations of modern finance.
If you have trouble dealing with the concept of a loan which pays interest
forever but never repays its principal, consider the modern U.S. 30-year
Treasury bond, which yields 60 semiannual payments of interest before repaying
its principal. During the past 30 years, inflation has averaged more than 5% per
year; over that period the purchasing power of the original dollar fell to less
than 23 cents. (In other words, the purchasing power of the dollar declined by
77%.) So almost all of the value of the bond is garnered from interest, not
principal. Extend the term of the loan to 100 years, and the inflation-adjusted
value of the ending principal payment is less than one cent on the dollar.
The historical European government annuity is worthy of modern consideration for
one compelling reason: its value is extremely simple to calculate: divide the
annual payment by the current (market) interest rate. For example, consider an
annuity that pays $100 each year. At a 5% interest rate, this annuity has a
value of $2,000 ($100/0.05 = $2,000). If you purchased an annuity when interest
rates were 5%, and rates then increased to 10%, the value of your annuity would
have fallen by half, since $100/0.1 = $1,000.
Excerpted from "The Four Pillars of Investing: Lessons for Building a Winning Portfolio" by William J. Bernstein. Copyright © 0 by William J. Bernstein. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided solely for the personal use of visitors to this web site.