BUY AND HOLD :

STILL BULLISH : Dow 36000 Revisited : Hey, be patient! (JAMES K. GLASSMAN AND KEVIN A. HASSETT, August 1, 2002, Wall Street Journal)

The theory that shaped our book comes from some powerful data. Ibbotson Associates, the Chicago research firm, found that from 1926 to 2001, the average annual return, after inflation, of the large-cap stocks of the Standard & Poor's 500 was 7.6%, compared with just 2.2% for Treasury bonds. In other words, stocks return more than three times as much as bonds. Thanks to compounding, after 30 years, an investment of $10,000 in stocks will rise, on average, to more than $90,000, while a similar investment in bonds will rise to less than $20,000.

Higher returns are normally correlated with higher risk, but work by Jeremy Siegel of the Wharton School and others has found that if stocks are held over long periods, risk declines dramatically. Mr. Siegel looked at nearly 200 years, and found that during their worst 20-year period ever, stocks rose more than 20%. But for bonds, the worst 20 years produced a loss of 60%. Mr. Siegel concluded that "the safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds."

How can bonds be risky? Nearly all bonds are exposed to inflation, which erodes principal. In an inflationary time, businesses can respond by raising prices, so stocks tend to suffer less than bonds. Stocks also increase their earnings fairly consistently from year to year, while bonds pay a fixed rate of interest, which is practically guaranteed to decline in purchasing power with inflation. Sure, there will be recessions and accompanying bad profit news from time to time. But in the end, the growing economy will pull firms' profits, and share prices, back upward.

For students of modern finance, the real mystery is how to reconcile these two facts: Over the long term, stocks return much more than bonds, but stocks are no more risky than bonds. This paradox is called the "equity premium puzzle"-- the premium being the extra return that stocks provide over benchmark bonds. For decades, economists were at a loss to explain the puzzle. A 1997 paper by Mr. Siegel and Richard Thaler of the University of Chicago concluded that the answer was "myopic risk aversion." In other words, investors are so frightened of short-term losses in the stock market
that they can't see beyond their noses.

We argued, to the contrary, that investors were finally solving the equity premium puzzle. Starting about 20 years ago, irrational risk aversion to stocks began to decline, thanks mainly to the spread of new research, better financial education, the rise of defined-contribution retirement plans, and increased world stability. [...]

Our noisiest critics, Paul Krugman in the New York Times and various Slate.com scribblers, willfully distort our arguments. And no wonder. If Americans continue to embrace long-term stock investing, the role of the state as dispenser of retirement benefits will shrink or disappear. And the "war" between capital and labor will be over. Unfortunately, many politicians and journalists have a vested interest in spreading fear and chasing people out of stocks--even though stock investing is the most reliable route to accumulating wealth.

The one thing I always tell younger folks who are hired at work is to put as much as they can in their 401k, put it in high return/high risk funds, and leave it alone for the next thirty years. When they're fifty they can start moving money over to bonds and whatnot. Or, when they're forty and have
so much money they can hire an investment counselor. Posted by Orrin Judd at August 1, 2002 8:27 AM