I think I know what Warren Buffet was trying to say. There has been an equity premium in the capital markets for a long, long time. Stocks have tended to return more than most other asset classes even after adjusting for risk. That equity premium remained in place for so long because most investors didn't even realize that it was there; essentially they thought that stocks would be more risky than they really turned out to be.
Now that the equity premium is more widely recognized and understood, traders have mostly arbitraged it away. So if present trends continue for the next 92 years then stocks may not return much more than bonds, real estate, commodities, etc. (At least not after you adjust for the actual risk.)
This is an interesting area of study, but I don't see how it concludes that bonds should do as well as stocks if the premium is truly arbitraged away. That is, if the premium is really gone, then it seems one should still expect stocks to do better than bonds because they make up a faster part of the economy’s growth curve relative to bonds.
Yes, they are riskier investments. But that is why you buy and hold them for the whole century (or at least as long as you can so the day to day risk smooths out a bit).
I don't understand what you mean about the economy's growth curve. But if what you think is correct then that implies you have discovered a trading rule! You should go short bonds and long stocks, and make yourself a fortune. ;-)
In the real world, capital markets tend to become more efficient over time as inefficiencies are arbitraged away. So it's unrealistic to expect that any particular asset class will outperform others on a risk-adjusted basis over a century.
What I mean is quite simple. Suppose the economy is growing at x%. That x% is made up of components. Some things are growing at smaller than x%, some larger. But when you sum them all together in a weighted fashion, you get x%.
Now bonds, on average, grow somewhere near x%, while stocks, on average, grow more than x%. And other things, like most savings accounts grow at less than x%. The reason stocks should grow faster is that they represent money that is being invested in new innovation (often technology), which have generally higher growth prospects than where the bond money is being invested (e.g. infrastructure).
If you look at the economy's growth curve, you can consider it made up of several different curves corresponding to different asset classes, which when summed together in a weighted fashion, yields the overall curve. The stock part makes up more of the growth component than bonds and that is what I meant by makes up a faster part of the growth curve.
This doesn't constitute a trading rule by any means. I'm not talking about any premiums or arbitrage opportunities. In fact, my comment said if the premium is really gone.
All I'm saying is I don't see how the area of study you referenced concludes that bonds as an asset class will grow at the same rate as stocks. And I still don't see it. Please enlighten me.
Note that I am not suggesting stocks outperform bonds on a risk adjusted basis. That's why I ended the comment saying they were riskier, and that, as a result you should buy and hold them.
The overall point here that I suppose I am making is that just because asset classes grow at the same rate when adjusted for risk doesn't mean you should be indifferent to which you invest in. Buying low, selling high aside, if you can smooth out the risk via buy and hold and other strategies, it is wise to invest some in the assets with the higher growth curves.
If stocks really grew faster than bonds (outside of risk), wouldn't it make sense for investors to take some of the money they have in bonds and put it in stocks, thereby increasing their total return? That'll drive the price of stocks up and the price of bonds down, driving total returns for stocks down and returns for bonds up (since you can get the same bond more cheaply). The process should only stop when investors are indifferent, on a risk-adjusted basis, to stocks & bonds.
That's what the grandparent means by "inefficiencies are arbitraged away".
As for equities funding more high-growth areas of the economy - you need to make a distinction between primary and secondary markets for capital. The primary market is where actual, producing firms offer part of their capital structure (either debt or equity) up for sale. This is often associated with entrepreneurs, investment bankers, venture capitalists, and private equity. The secondary market is where financial firms trade securities of existing companies - hedge funds, mutual funds, and retail investors.
In the secondary market, investors always have the option of bidding up the prices of securities that they really, really want. As a result, it doesn't matter how well the economy does, it only matters how well the economy does relative to how people expected it would do. If people expect the economy to shrink 10% but it really shrinks 5%, stocks (in the secondary market) will jump. If they expect it to grow 20% but it really grows 15%, stocks will crash, even though absolute growth rates are significantly higher. That's why only unexpected earnings have an effect on a company's stock price.
The primary market is much less liquid and hence less subject to arbitrage opportunities. If a company is growing very well, it will be able to charge a higher price for its securities, and the proceeds will go directly to its balance sheet.
So, the fact that high-growth industries tend to be financed with equity rather than debt means a lot for entrepreneurs and venture capitals, but very little for investors in the public markets. For that matter, a number of studies have found that "growth" stocks do significantly worse than "value" stocks, because investors consistently overweight their growth prospects.
I said in my comment specifically Note that I am not suggesting stocks outperform bonds on a risk adjusted basis. It seems your whole comment assumes the contrary as it opens with If stocks really grew faster than bonds (outside of risk). This assumption is simply not true.
However, given your comment, would you suggest an investor invest in stocks at all in a buy and hold strategy (as opposed to merely speculation on the price being low at the moment)?
I think what you're trying to say is that is in the long run, equities (relative to debt securities) will contain an increasing share of the total wealth in the whole economy. That may or may not be correct, but it's irrelevant to Warren Buffett's original statement or the equity risk premium. What we're discussing here are the returns an individual investor should expect to receive from stocks in general.
Buying and holding individual stocks is a bad strategy for a long-term investor. Eventually a lot of those stocks will go to zero. In most cases you'll be better off with a passively-managed index fund which periodically rebalances based on market capitalizations.
No, that's not what I'm saying at all, but let's just move on. (We can take it off-board if you want though.)
Also, I never suggested buying and holding individual stocks. I agree that one should only buy and hold that type of index funds.
As for the relevancy of this discussion, I was just responding to your comments. The original post was just about a dumb argument made by Warren Buffett, and not about equity premiums or any other underlying issue at all. In fact the post closed with This is not a discussion about whether we are actually in for similar, higher, or lower returns. Let's leave that for another day. This is just to say that this argument for lower returns is ridiculous!
That being said, with your belief in the equity premium theory, do you believe there is any scenario where investing in stocks long term (say buy and hold for the century) makes sense?
Sure, it makes sense to put a share of your assets into low-cost equity index funds which base allocation weights on market capitalization. Note that the DJIA (mentioned in the original article) isn't a suitable index for this because its 30 components are picked more or less arbitrarily by the Dow Jones staff.
But this is what I was getting at. You say to buy stocks, in a good index mind you, but you also say they are no better as an asset class when you adjust for risk. So why buy them?
Or do you agree with my point from above?:
The overall point here that I suppose I am making is that just because asset classes grow at the same rate when adjusted for risk doesn't mean you should be indifferent to which you invest in. Buying low, selling high aside, if you can smooth out the risk via buy and hold and other strategies, it is wise to invest some in the assets with the higher growth curves.
I partially agree with you. While I don't think equity index funds will have higher risk-adjusted returns than any other asset class, they are still useful for diversification. By building a portfolio of uncorrelated or negatively-correlated investments, investors can somewhat reduce the total risk while retaining most of the gains. Personally I try to maximize the expected Sharpe ratio of my portfolio as a whole. This isn't exactly a buy-and-hold strategy; it requires rebalancing the portfolio whenever market moves cause the current asset allocation weights to drift too far from the target.
I could tell you, but the answer wouldn't be applicable to your or anyone else. Almost all of my long-term investments are in a certain retirement account that only provides a limited set of mutual funds as investment options. If I could invest in anything then I'm sure I would have different allocation targets, but since I can't then I haven't bothered to figure it out.
What I have done is write a small program which can take a set of allocations for portfolio components and then calculate an expected Sharpe ratio for the whole portfolio by using a Monte Carlo simulation run over hundreds of years using historical returns data. It then uses simulated annealing to do a constrained optimization over the solution space. This is only feasible because there are only about 20 available portfolio components. There are also no capital-gains taxes, transaction costs, shorting or borrowing, all of which keeps things reasonably simple.
Of course historical returns are a poor predictor of future performance. But historical correlation coefficients are a reasonably good predictor of future correlations, which is mainly what I am after with trying to find the best diversification.
Actually at the moment I have the majority in a money-market fund just because I'm trying to time the market and play a hunch. But that's usually a poor strategy and I wouldn't recommend it to anyone else.
I had exactly the same reaction when I got to that part of the letter. I think you can take any trend and extrapolate it into incredulity -- Buffett's career is certainly evidence of this.
This "1900 to 2000" trend people are extrapolating from is a myth. Stocks, as a broad category, have historically not been a great investment. Almost all the gain in that period happened in the last 20 years. If you break equity returns down into all possible 40 year periods returns were lousy.
This is taking the index numbers at face value. Better assessments of returns using good inflation numbers and incorporating tax liabilities make the picture much worse.
http://www.itulip.com/realdow.htm
Finally, the real sample size goes back much farther than 1900. We have good equity price data back into the 18th century. 80% market crashes were common. Overall returns were not good.
Stocks were cheap in 1980. Then they soared in price for 20 years. Now people are slow to realize that period was exceptional. Investing is about "buy low, sell high" not "stick your money in stocks." Stocks are high. The smart money bought commodities in the early 70s, changed to bonds in the early 80s, changed to stocks in the early 90s, and changed back to commodities in the early 2000s. That smart investor has absolutely crushed an equity fixated investor. This isn't rocket science, either. It's not that hard to review asset classes once a decade and figure out what's very cheap and what's expensive.
I don't know what an investor should do--I just watch the money move. Money will always flow somewhere, because it has to.
Where will it flow next? Probably wherever it isn't this time.
Right now commodities (a.k.a. "stuff") is getting the attention, as some have predicted for years (someone's always predicting something for years, until it comes true).
Recently: Tech -> Housing -> Stuff -> ?
A problem for people with money to worry about. ;)
this question is why the financial institutions exist. companies that do nothing but solicit your money and invest it for you while living off a percentage don't really know all that much about how the markets work. Like the previous poster said, you have to be a contrarian. It's exactly that ability to invest in something when everyone thinks it is worthless that makes people rich. stocks were dirt cheap in the 80's, commodities were dirt cheap in the early 2000's, you have to figure out on your own where to go next.
I will say that these trends seem to have followed a 17 year period (on average) during the 20th century. If this remains true america has another 9 years of slow economic growth (and commodities have another 9 years of bull).
But we must always beware of the induction fallacy :)
Looking at this thread, I think it would be very useful to link comments on news.yc to disqus (so they show up on the blog post). I'm sure the disqus guys can do that.
So, on a related note... Google has grown really fast over 5 or so years. Say, 12,385% for the sake of argument. What do you think the chances of this experiencing that PERCENTAGE growth over the next 5 years?
I think his point is-- high percentage growth is easy for small things. It gets harder for big things. Growth curves tend to flatten out.
That being said, I agree with your underlying point: bigger things are harder to move % wise. However, when you consider the overall economy, it isn't as clear cut as Google (and Google isn't that clear cut!). There are so many factors to consider, including population growth, rate of integration of certain populations into the "developed world," resource constraints, innovation growth %, etc. etc.
The Dow should increasingly roughly move at a small multiple of the growth of the global economy. So if one says you shouldn't expect the same returns, one is essentially saying that the global economy is going to slow down as a whole relative to the past century. I just haven't seen any compelling evidence for this claim. Sure, I have seen wild speculation and isolated scenarios, but I have not seen any well-thought out arguments that really attempt to capture all the factors in a probabilistic fashion.
The best evidence I have seen is that developed countries tend to have slower growth rates after a certain point. But this is a recent trend, not universal, and of course not perpetually written in stone.
Growth curves for a single company flatten out because a single company can never be larger than the entire market (and in practice never even close to that large). If Google were to grow indefinitely it will eventually become 100% of the economy, swallowing all other companies and employing everyone, but even at that point it would still grow, but only at the rate the entire economy grows.
Growth for the entire economy is only limited by our abilities to innovate and find resources (both material and human resources). There is no inherent ceiling. The ceiling on a single company (which makes it's growth rate fall off) is imposed when it saturates it's market and can't enter any new markets, the economy as a whole is fueled by the seemingly endless wants of humanity. In essence, there is always a new market for the economy to enter: the next human desire.
In short, the only way there could be a ceiling on the entire economy is if humans stopped wanting new things. Economic growth is supply constrained (supply of resources and innovation), not demand constrained.
I guess I should have clarified that I meant there was no inherent ceiling on the size of the economy (other than the amount of mass and energy in the known Universe, although I hope we'll figure out something else to do before we consume all that), but yes, the growth rate in any given year is limited by resources available and human innovation. Sorry for the ambiguity.
I guess my point is that the reason high percentage growth is easy for small companies is because they can rapidly expand to fill an existing market that is much bigger than the company. The reason it is hard for big companies is because of market saturation.
The economy as a whole doesn't work that way. It just relentlessly grows with our ability to acquire resources and never-ending human desires.
Material and human resources are only finite if you believe in a finite universe. And even then, we can keep growing as a species indefinitely in the medium to long term, and keep growing resource wise as well. We have only just begun to tap nuclear or solar energy, and we can expand beyond the Earth to Mars, and eventually to other parts of the solar system and beyond.
The DJIA is not a single "thing" that is subject to the same growth rules as a single organization -- it is just an index of companies. The same properties that allowed the index to grow from 66 to ~11,000 in the 20th century could just as easily allow it to grow by a similar percentage in the 21st century: the absolute value of the index is not relevant (it already accounts for stock splits).
Well, all "things" are made up of smaller "things"... Because the DJ is made up of smaller things, it's not subject to any growth rules? I'm not sure why you'd draw a line there.
The question that Buffett is addressing is, "Is there as much potential for growth among these companies (and the economy as a whole) as there was 100 years ago?" His answer is no. While I'm not convinced, I don't think it's a "dumb" conclusion.
I didn't say it was a dumb conclusion, but just that the particular argument made to support it was dumb.
In particular, I qualified with Now there may be reasons not to expect similar returns in this century as compared to the last, but this is certainly not one of them. and This is not a discussion about whether we are actually in for similar, higher, or lower returns.
There may well be reason to conclude that there is less potential for growth -- the problem is that his reasoning for making that conclusion is based on the absolute value of the Dow index, which is what is dumb.
He doesn't seem to be taking into account new markets that might soon exist. We had TV's, space travel, the Internet, Y Combinator and wireless communication in the 1900's alone!
The point wasn't that 2 million is a huge number, but that 5.3% is just as huge. The millions are the eye-catching part, but this looks like an odd way of saying a risk-adjusted 5% return is insane, and 10% (the target for a '90s-era portfolio) is not twice but ten times as insane, in the long run.
Who says you have to invest in Dow Jones' market during the 21st century? I'm sure it wouldn't be hard to get a 5.3% return in a more emerging market like, say, India or China.
An investor who wants the most return with the lowest risk will have a balanced portfolio across many asset classes, which would include both the Dow stocks and India and China in some fashion. That being said, the Dow companies already get a significant % of their earnings abroad. And this % is increasing.
Don't get me wrong, I completely agree with the original author. Warren's logic is circular and seems to be preying on people's inability to conceive of very large numbers. I'd fully expect DJIA to continue growing at roughly the same pace this century as the last.
Even if it doesn't, though, everyone knows that the trick to successful investment is to buy low and sell high. There are still plenty of opportunities to buy low - even with limited risk - in large emerging economies. The U.S. may become a low-risk capital preservation stock and China will become the higher-risk investment stock.
Actually it will be hard to get that kind of return in emerging market stocks for three reasons.
1) Emerging markets tend to be riskier, so if you look at it on a risk-adjusted basis the expected returns don't look as good. What happens to your assets if China has another revolution?
2) As a practical matter, an individual US citizen just can't buy equity in many emerging market companies. Either they aren't listed on US exchanges, or are privately held, or national goverments have ownership restrictions in place. There isn't even much in the way of mutual funds to do it indirectly.
3) The few stocks in the BRIC markets available for direct purchase by individual outside investors have already been bid up to ridiculous levels by dumb money who think they can't afford to be left behind. You may be waiting a very long time to see much significant upside.
I think there are two sides to what Warren Buffett is saying. One side is nonsense, I agree - that he can make a prediction like that based on early trends. The other side, however, which is what I think he actually meant, is that, in fact, predicting from trends is not nearly what it's cracked up to be, and that there is no real guarantee of continued healthy returns from US equities, or even long-term returns to capital that are comparable to the low double-digit returns of the 20th Century. That's a legitimate point.
It is utterly reasonable to argue that past returns are no guarantee of future returns, but if that is the argument he meant to make, he did it exceedingly poorly.
Now that the equity premium is more widely recognized and understood, traders have mostly arbitraged it away. So if present trends continue for the next 92 years then stocks may not return much more than bonds, real estate, commodities, etc. (At least not after you adjust for the actual risk.)
http://en.wikipedia.org/wiki/Equity_premium_puzzle