What is the best thing to invest in? Stocks—by a mile

Since 1802 the dollar has lost 95 per cent of its purchasing power. After inflation, a dollar invested in stocks in 1802 would’ve soared to $704,997 by 2012. A dollar invested in long-term U.S. government bonds would’ve climbed to $1,178 by 2012. A dollar invested in U.S. Treasury bills in 1802 would’ve grown to $281 by 2012. And a dollar invested in gold would’ve inched up to $4.52 by 2012, after inflation.

Jeremy Siegel is a professor of finance at the Wharton School of the University of Pennsylvania. He also wrote the book Stocks for the Long Run. Professor Siegel believes that the most important chart in his book is the one that shows historical real returns for different asset classes since 1802.

Professor Siegel writes that the chart “traces year by year how real (after-inflation) wealth has accumulated for a hypothetical investor who put a dollar in (1) stocks, (2) long-term government bonds, (3) U.S.  Treasury bills, (4) gold, and (5) U.S. currency over the last two centuries [1802 to 2012]. These returns are called total real returns and include income distributed from the investment (if any) plus capital gains or losses, all measured in constant purchasing power.

Stocks easily beat bonds, T-bills and gold

“The compound annual real returns for these asset classes are also listed in the figure. Over the 210 years I have examined stock returns, the real return on a broadly diversified portfolio of stocks has averaged 6.6 percent per year. This means that, on average, a diversified stock portfolio, such as an index fund, has nearly doubled in purchasing power every decade over the past two centuries. The real return on fixed-income investments has averaged far less; on long-term government bonds the average real return has been 3.6 percent per year and on short-term bonds only 2.7 percent per year.

“The average real return on gold has been only 0.7 percent per year. In the long run, gold prices have remained just ahead of the inflation rate, but little more. The dollar has lost, on average, 1.4 percent per year of purchasing power since 1802, but it has depreciated at a significantly faster rate since World War II.”

The gold standard kept inflation in check

In fact, from 1802 until World War II, the dollar retained its purchasing power. That’s because the world operated on what’s known as the ‘gold standard’. Under this system, you could print currency only if it was backed by gold. The supply of gold usually increases slowly. As a result, the number of bills in circulation also grew slowly.

To finance the war effort, however, countries abandoned the gold standard. This allowed governments to print as many bills as they wanted. After World War II, many governments faced enormous debts. But as the number of bills rose, so did inflation. This effectively reduced the debt in real terms.

The world never went back on the gold standard. As a result, the purchasing power of most currencies plummeted. By 2012, for instance, one dollar had declined to a nickel. This means that a dollar today can buy what only five cents could have bought between 1802 and World War II. The abandonment of the penny in Canada shows how corrosive inflation is. But stocks are different.

Stocks deliver stable real returns

Professor Siegel writes, “The stability of real [stock] returns is striking; real stock returns in the nineteenth century do not differ appreciably from the real returns in the twentieth century…stocks fluctuate both below and above the trendline [of 6.6 per cent] but eventually return to the trend. Economists call this behavior mean reversion, a property that indicates that periods of above-average returns tend to be followed by periods of below-average returns and vice versa. No other asset class—bonds, commodities, or the dollar—displays the stability of long-term real returns as do stocks.

“In the short run, however, stock returns are very volatile, driven by changes in earnings, interest rates, risk, and uncertainty, as well as psychological factors, such as optimism and pessimism as well as fear and greed. Yet these short-term swings in the market, which so preoccupy investors and the financial press, are insignificant compared with the broad upward movement in stock returns.”

 

The Investment Reporter, MPL Communications Inc.
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