Flush with enthusiasm, which is his way, my friend and colleague Kevin Hassett barged into my office at the American Enterprise Institute 24 years ago to tell me that he had a solution to what economists called the “equity-premium puzzle.” I had no idea what he was talking about.
Kevin’s notion, which I eventually came to understand and embrace, was the germ of our article in the Wall Street Journal on March 3, 1998, with the headline, “Are Stocks Overvalued? Not a Chance.” You need to understand the context. The years 1995 to 1998 were the best in U.S. stock-market history. On December 5, 1996, Alan Greenspan, the chairman of the Federal Reserve, had warned of “irrational exuberance” in a speech at AEI’s annual dinner. On that day, the Dow closed at 6,437, having doubled in four years. On the day our article was published in the Journal, it was 8,782. We argued that a truly rational level for the Dow was 35,000. A year and a half later, with the market still climbing, we made a few adjustments and published a book called Dow 36,000.
Now it’s happened. Right after the stock market opened on November 1, the Dow hit 36,009. The index has returned 457 percent since the book came out. In other words, if you had put $10,000 into the 30 stocks of the index on the day of publication and reinvested the dividends in more shares of those stocks, your final investment would have grown to $55,700.
Dow 36,000 was widely mocked for its title. “Even in those heady days,” wrote Zachary Karabell recently in the New York Times, “forecasting a near-quadrupling of the index appeared naïve at best and ridiculous at worst.” In fact, our prediction was modest. History shows that putting your money in the U.S. stock market and keeping it there over a long period—at least 10 years and, better, 20 or more—has almost always been a good bet. Five years before Dow 36,000 was published, Jeremy Siegel, a Wharton economist, developed a dataset of stock and bond performance going back nearly 200 years and concluded, “It is very significant that stocks, in contrast to bonds or bills, have never delivered to investors a negative real return over periods lasting 17 years or more.” Since 1909, there have been only four rolling 10-year periods (that is, 1909–1918, 1910–1919, etc.) when the stock market has lost value.
There are two reasons the market has done so well. The first is a paradox. People are scared of stocks. Because they think stocks are riskier than they really are, investors price them to yield a high return (a point I’ll explain further). The second reason is easier to understand. Stocks do well because the U.S. economy does well. An investment in the stock market—especially the broad market that the Dow Jones Industrial Average has represented since Charles Dow first compiled it in 1896—is an expression of faith in American business and in public policies that, despite many false steps, generally allow people and markets room to innovate and thrive.
What’s still missing in those policies is encouragement for much broader stock ownership. According to Gallup, when Dow 36,000 was published, 60 percent of U.S. households owned stocks, stock mutual funds, or 401(k) plans with stock investments. Last summer, the figure was 56 percent. That nearly half of Americans have no stake in the nation’s best companies is a crime.
The story of Anne Scheiber shows what they have missed.
IN THE EARLY DAYS of 1995, a man named Benjamin Clark dialed up Norman Lamm, an Orthodox rabbi who was president of Yeshiva University in New York City, and asked for a meeting. The two got together a few days later. Clark, an attorney, told Rabbi Lamm that his client, who had died weeks before, had bequeathed a huge amount of money to Yeshiva. It turned out to be $22 million, the second-largest gift in the university’s history.
Clark’s client, Anne Scheiber, was not particularly religious and had no connection at all to Yeshiva (she had gone there once for a lecture). Lamm had never heard of her. Scheiber gave the majority of her estate to Yeshiva’s Stern College for Women, Clark said, because “it is the only college for women in America that is under Jewish auspices.” More precisely, the bequest was an act of revenge. Scheiber believed that, as a Jew and a woman, she had been prevented from advancing by her employer, the Internal Revenue Service, and she wanted other women, especially Jewish women, to get an education that would give them the knowledge and confidence to succeed. She also wanted to deny the IRS any bit of the wealth she had acquired in the stock market by refusing to take capital gains and then donating her assets at death to a university.
Upon her retirement in 1944, Scheiber invested her entire life savings—$5,000—in stocks such as Schering-Plough (a venerable pharmaceutical manufacturer), Allied Chemical, and Coca-Cola, and turned the investment into $22 million.
Although she had a law degree, Scheiber never earned more than $3,150 a year, the equivalent of less than $50,000 today. She had a tiny, $450-a-month apartment with paint chipping from the walls. Her passport, said an article in the Observer, the Stern College newspaper, “had a single stamp from a European vacation she took 60 years ago.” Anne Scheiber accumulated her riches by investing a small amount of money in the stock market when she retired as an IRS auditor at the age of 50 and leaving the shares to grow in her account.
She turned $5,000 into $22 million in part because she was a good stock picker who lived to be 101, but her real talent was fortitude. She bought and held the shares she owned no matter what happened around her: World War II, Korea, the Kennedy assassination, stagflation, the Nixon resignation, and the horror of October 19, 1987, when the market lost 22.6 percent in a single day.
MARKETS HAVE always been and will always be forced to contend with adversity. Since the publication of Dow 36,000, we’ve been through 9/11, the worst economic decline since the Great Depression, and the worst pandemic in a century. The Dow fell by more than half between its peak in the fall of 2007 and its nadir in the spring of 2009. When investors recognized the full impact of COVID-19, the Dow dropped 10,000 points in a month. In either of those cases, if you had sold your stocks, you would have missed massive recoveries.
Over the past century or so, stocks have returned an average of about 11 percent a year including dividends—while U.S. Treasury bonds have returned about 5.5 percent. The difference between the two is called the “equity risk premium”—that is, the extra amount that stocks pay investors to compensate for the difference in risk between stocks and bonds. In 1985, economists Rajnish Mehra and Edward Prescott (the latter won the Nobel Prize in 2004) formulated what they called a “puzzle” in a widely cited article in the Journal of Monetary Economics. Their puzzle: In fact, stocks, as Siegel and others showed, are no more risky than bonds, so why should they pay investors more? It would be like paying even money if heads turns up on a coin flip—but 2-to-1 if tails comes up. As Princeton economist Burton Malkiel wrote in a review of our book, “the extra 5.5 percentage points from owning stocks over bonds…is unjustified.”
The reason Kevin Hassett, who would later become chairman of the Council of Economic Advisers, burst into my office 24 years ago was that he had become convinced that investors were solving the equity-premium puzzle by bidding up the prices of stocks to where they should be, considering that their true risk was lower than markets were recognizing. Someday soon, we wrote, stocks would get to a reasonable—that is, much higher—level, and future returns would decline.
This concept is a little tricky. But realize that, if prices suddenly go up, then returns go down. Imagine a company has a constant stock price of $100 and a dividend of $5. Its return is a consistent 5 percent. Now imagine the price of the stock suddenly jumps to $500. The dividend, a function of the company’s operating profits, stays the same at $5, so the return drops to 1 percent.
Our thesis was that we were on the verge of a big jump in stock prices that would rationalize the weirdly high premium that stocks paid over risk-free bonds. The strategy we advised was simple: Buy stocks and hold them, just like Anne Scheiber. Even if it took a long time for the puzzle to be resolved, investors would continue to benefit from what Malkiel called the “unjustified” returns paid by stocks.
As it turned out, the equity premium has persisted, so you might say that our thesis was wrong. On the other hand, our buy-and-hold strategy was right. And we’re certainly not complaining. If the stock market wants to pay investors much more than its riskiness would seem to permit, then fine.
BUT WHERE did we go wrong? For starters, we should have had more respect for the judgment of the market: that is, the millions of people around the world who decide to buy and sell shares based on what they perceive to be the prospects for thousands of businesses. These investors demand double-digit returns for the risks they are taking, and it is an act of hubris to second-guess them.
The risks that investors perceive are not necessarily the risks that economists define. Financial risk is generally measured by examining variations in returns. If a company’s shares bounce up and down in extreme ways, those shares are considered risky. Even in a diversified portfolio, such as the 30 blue-chip stocks of the Dow, returns are volatile in the short term but remarkably stable over long periods—and, after accounting for inflation, they are actually less volatile than Treasury bonds. But investors don’t react according to their long-term perceptions. They can’t help but be affected by current or recent shocks like 9/11 or COVID-19. And there is always the chance of worse to come.
Frank Knight, who grew up in poverty on a farm in Illinois and eventually taught economics at the University of Chicago for 44 years, made a distinction between financial risk and what he called “uncertainty,” which is utterly different. Risk involves probability that we can know and measure by looking at history. “Extrapolation of past frequencies is the favored method for arriving at judgments about what lies ahead,” wrote the economist Peter L. Bernstein in Against the Gods, a history of risk. After all, the past is all we have to go on.
But in his 1921 book, Risk, Uncertainty, and Profit, Knight was talking about events unseen in the past: a bolt from the blue, planes crashing into the World Trade Center, the “black swans” we can’t possibly predict. Investors are smart enough to understand that such things can happen even if they can’t know what they are in advance. Drawing on Knight, John Maynard Keynes wrote in 1937, “About these matters, there is no scientific basis on which to form any calculable probability whatever. We simply cannot know!” The crazy short-term ups and downs of markets offer premonitions.
INVESTING IS a contest between a scary short term and a more stable, fruitful long term. Like Anne Scheiber, you get paid for perseverance—or, as I said earlier, for faith. It’s important to be reminded once in a while that there is a basis for such faith. America’s businesses and our economy are unsurpassed—miles ahead. U.S. gross domestic product has declined just eight times in the past 50 calendar years, and only three of those declines exceeded 1 percent. All but two of the eight declines were erased by greater growth the next year. The U.S. economy remains by far the largest in the world, 50 percent bigger than China’s, which has four times the American population.
The U.S. leads the world in technology, pharmaceuticals, and oil exports, in consumer-product innovation, marketing, entertainment, in Nobel Prizes, weapons production, athletics, and graduate education. Over the last 10 years, the U.S. benchmark equity index, Standard & Poor’s 500, has returned an annual average of 16 percent while the MSCI EAFE index, which reflects the performance of stocks in the rest of the world, has returned just 7 percent.
The ultimate reason that U.S. stocks are such a good investment is that the U.S. is such a good investment. The problem is that so few Americans are benefiting through stock ownership. In his Times piece, Karabell urged Congress to draw up “innovative laws and nuanced rules to better distribute the gains of capitalism.” And he asked, “Why not use the tax code to nudge companies to give all workers shares in the company so that labor enjoys some of the benefits of capital? Or tie wage increases to the profitability of the company rather than indexing them to inflation?”
No, please don’t. There’s no need. Just make it easier for people to own stock. The Individual Retirement Account, or IRA, was launched by legislation in 1974, and the 401(k) plan, which let companies provide tax-deferred stock and bond accounts to their employees, was part of the Revenue Act of 1978. The Roth IRA, introduced in 1997, let Americans withdraw their accumulated assets tax-free. All of these retirement vehicles have severe limits on how much you can invest and when you can take the money out.
A better system would merely allow anyone to make stock and bond investments of any size for a prescribed holding period—say, 10 years—and make tax-free withdrawals for reasons of one’s own choosing. Alas, low-income Americans would be left out. If they’re living from paycheck to paycheck, they don’t have anything left over to invest. That’s a reason to resurrect an old idea that was practically killed off by the 2008 recession: opt-in private stock accounts as part of Social Security.
Workers would be able designate part of their payroll taxes to go to a stock index fund with a commensurate reduction in government-provided retirement benefits. Not only do stocks return more than the returns to Social Security contributions, but workers would be able to build up assets that they could pass on to their heirs. In a virtuous circle, more private investment helps the economy as well by increasing the savings rate.
IN WRITING ABOUT investing for more than 40 years, I have come up with my own equity-premium puzzle. Why is it that more people aren’t like Anne Scheiber? The U.S. economy has shown its mettle, and investing has become a ridiculously simple proposition. Low-cost index funds make it easy to get cheap diversification. The SPDR Dow Jones Industrial Average exchange-traded fund, nicknamed Diamonds, allows you to buy the 30 stocks of the Dow for an annual expense ratio of just 0.16 percent. Or if you want a broader bunch, the Vanguard 500 Index, a mutual fund whose portfolio comprises the 500 large-capitalization companies of the Standard & Poor’s 500, charges 0.14 percent.
The hard part is discipline or, better, faith—even in the face of politicians with their trillion-dollar social-welfare bills. My recommendation is to pay no attention. Just have your broker or your bank withdraw the same amount each month from your checking account or paycheck and buy more shares of the Dow or the S&P. Stock prices, which look to the American future with confidence even if the rest of us sometimes don’t, will keep going up.
It’s the ultimate safe bet.
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