Wikinvest Wire

More bad news for retail investors

Saturday, July 11, 2009

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".

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