12/01/1997
The volatility of year-to-year stock returns is so great that it's very hard to measure average returns with any sort of statistical certainty. The best that statistics can do is to say we are 95 percent certain that the true average excess return is between 3 percent and 13 percent.
It's become a staple of financial advice, dispensed by stockbrokers, securities analysts, and the media: Common stocks outperform other investments over time, and they outperform them by a lot. Therefore, the reasoning goes, it makes sense to overweight your portfolio with stocks.
Historically speaking, that's been true enough. Since World War II, stocks have returned an average of 8 percent a year more than Treasury bills. But that bit of information begs a few questions. For one thing, is the 50-year period since the end of the war long enough to yield statistically reliable data about stock and bond returns? Is there any good reason that stocks should so clearly outperform bonds? Can any of this historical information really tell us what stocks will do in the future?
In Where is the Market Going? Uncertain Facts and Novel Theories (NBER Working Paper No. 6207), NBER Research Associate John Cochrane concludes that while the excess return for stocks is real, it's not necessarily 8 percent. The volatility of year-to-year stock returns is so great that it's very hard to measure average returns with any sort of statistical certainty. The best that statistics can do is to say we are 95 percent certain that the true average excess return is between 3 percent and 13 percent.
Why do stocks outperform bonds? The obvious answer is that stocks are riskier than bonds, and investors are risk averse and thus demand a higher return when they buy stocks. But standard economic models don't predict nearly enough risk aversion among consumers to explain an 8 percent excess return for stocks. Novel theories can explain the 8 percent excess return, but they fundamentally change the story of risk and risk aversion, in ways that have not yet been widely examined. These facts suggest that the 8 percent postwar excess return was a fluke.
This bearish implication is reinforced by the fact that periods of high stock price-to-dividend ratios (or price-to-earnings ratios) are usually followed by lower-than-usual stock returns, and price-to-dividend ratios are higher now than they have ever been. Cochrane concludes: ``We might interpret the recent run up in the market as the result of people finally figuring out how good an investment stocks have been for the last century, and building institutions which allow wide participation in the stock market. If so, future returns are likely to be much lower."
