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100 acorns back upon retrieval because some have decayed or been eaten
by other animals. If a squirrel buries 100 acorns and later eats only 80, it
has just accepted an interest rate of negative 20%. Squirrels must accept
negative interest rates because they have no better storage options.
Modern industrial societies have highly secure, low-cost storage
options for money. A safety deposit box that is rented for a few dollars a
year can hold a lot of cash. Thus, unless one fears a breakdown of civi-
lization, interest rates cannot go below zero. No one is going to accept a
promise of less than $100 for an investment of $100. The fact that inter-
est rates cannot go below zero means that the majority of the bull market
in bonds has already occurred. To be precise, interest rates have gone
from above 12% to below 4% in the last 20 years. That means we™ve
already seen at least two-thirds of the entire bull market in bonds.



Buying Bonds at the Wrong Time

The bull market in bonds that began in the early 1980s has largely run its
course. The majority of possible profits has already been made. This does
156 Applying Science and Art to Bonds, Stocks, and Real Estate



not mean that bonds are bad investments now, but it does mean that they
cannot be fantastic investments.
It is easy to calculate the maximum returns on bonds. Consider our
$1,000 investment in a 10-year Treasury bond at 4% per year. How much
can our bond buyer make? If interest rates went to their theoretical mini-
mum of zero, the bond would jump in price from $1,000 to $1,400. So
the absolute maximum gain on the 10-year Treasury bond is 40%.
Recall that in the early 1980s, I ignored the advice to buy the Reagan
bonds. Other investors apparently shared my view. The data on invest-
ments into bond mutual funds reveal that investors really started loving
bonds only when the stock market tanked in the last few years. In fact,
bond mutual funds took in all-time record amounts in 2002.8 This
appears to be another example of investors being completely out of sync
with investment opportunities. Bonds were an amazing opportunity in
the early 1980s, but by the time investors got really excited about bonds,
the majority of the bull market in bonds was over.
In the mockumentary This Is Spinal Tap Rob Reiner plays Marti
DiBergi, a filmmaker touring with the world™s loudest band. In perhaps
the most famous scene of the movie, Nigel Tufnel (played by Christopher
Guest) reveals the band™s secret. Spinal Tap is the world™s loudest band
because their amplifier “goes to eleven” and not just to 10.
DiBergi asks, “Does that mean it™s louder? Is it any louder?”
Nigel responds, “Well it™s one louder. Isn™t it? It™s not 10. You see,
most blokes are going to be playing at 10. You™re on 10, here all the way
up, all the way up, all the way up. You™re on 10 on your guitar. Where can
you go from there? Where? . . . Nowhere. Exactly. What we do, if we
need that extra push over the cliff, you know what we do?”
DiBergi offers, “You put it up to 11?” to which Nigel responds, “Eleven,
exactly, one louder.” Puzzled, DiBergi asks, “Why don™t you just make 10
louder and make 10 be the top number, and make that a little louder?” After
a stunned silence, the scene ends with Nigel saying, “These go to 11.”
The new version of the Oxford English Dictionary includes “goes to
Bonds 157



eleven” to mean to put to the maximum volume. The majority of the bull
market in bonds is over because, metaphorically, bonds cannot go to
eleven. Where can you go from a 4% interest rate on the 10-year Treasury
bond? Nigel Tufnel would respond with “nowhere.” So perhaps bonds in
this environment are not for wimps, but rather for risk-takers.



Protecting Investments from
Changing Interest Rates

What are the implications of this analysis for investors? The 20-year bull
market in bonds has largely run its course. U.S. bond prices can fall, go
sideways, or rise very modestly. The huge gains of the last two decades
cannot continue. In addition, it is likely that the inflation adjusted (real)
interest rate will rise.
This is a toxic environment for the backward-looking, pattern-seeking
lizard brain. Bond prices have risen for the past 20 years, and the lizard
brain is built to predict that the trend will continue. Yet we know that
interest rates cannot go below zero. Thus, we have a pending collision
between the assumption of the lizard brain and economic reality.
The implication is that most of us have too much riding on low inter-
est rates. The lizard brain has been lulled into interest rate overconfi-
dence by the unsustainable 20-year bull market of rising bond prices and
falling interest rates. Thus, most people should adjust their financial posi-
tion to have lower exposure to rising interest rates. There are three ways
to protect ourselves from interest rate rises.

Tip #1: Borrow at Fixed Rates
Borrowing at fixed interest rates reduces risk. If interest rates rise then it
will be great to continue to enjoy today™s low rates. If interest rates fall
substantially, then it is always possible to refinance. Thus, fixed-rate debt
is lower risk than adjustable or floating rate debt.
158 Applying Science and Art to Bonds, Stocks, and Real Estate



Tip #2: Lend Short-Term
If you own bonds, you are a lender. The shorter the term of your loan, the
less risk you face from interest rate changes. If you own U.S. government
bonds, for example, those that mature soon are less risky than those that
mature later.

Tip #3: Borrow Less
If the inflation-adjusted interest rate rises, then the burden of debt will
increase. One obvious way to decrease the burden of rising rates is to
reduce the amount of borrowing. For those with nonmortgage debts, one
route is to sell some stocks or other assets and pay off some debt. Those
with mortgage debt can prepay a chunk of the principal. (Some mort-
gages do not allow or reward partial prepayment, but these mortgages can
be refinanced if necessary.)

Acting on these tips will reduce risk and position the investor for profit.
It is possible to benefit from rising interest rates. The financial media
suggest that rising interest rates would hurt the economy with no bene-
fits. This analysis suffers from two flaws.
First, if the economy is strong, interest rates will rise. One of the few
ways to have continued low interest rates is to have a recession or worse.
U.S. interest rates in the Great Depression were close to zero. Similarly,
Japan has “enjoyed” low interest rates recently because it has suffered
through 15 years of economic malaise.
Second, rising interest rates are great for savvy savers. Savers would
prefer to get those superhigh interest rates of the early 1980s rather than
today™s puny returns. In order to profit from a rise in rates, however, it is
important to buy bonds after the rates have risen. Thus, implementing the
previous tips will position an investor to benefit from rising rates.
Making money in this interest rate environment requires overruling
the lizard brain. The correct course now is likely to be the opposite of
what has worked for the last generation. The lizard brain has been fooled
by 20 golden years of falling interest rates and rising bonds prices.
chapter eight


STOCKS
For the Long Run or for Losers?




“If you had $1 million, what would you do with it?” My students in the
spring of 2001 pondered this question. At the time, I was a visiting pro-
fessor at my alma mater, the University of Michigan. My roommate from
my undergraduate years, Peter Borish, had returned to give a short guest
lecture to this class of about 150 college students, many of them major-
ing in economics.
Peter Borish is a famous and accomplished investor. Before posing
this investing question, Peter™s comments made it clear that he was
extremely knowledgeable and sophisticated about the world of finance.
Accordingly, the class was a bit tense as many students thought they
knew the “right” answer, but were intimidated. After what seemed like a
long time, Gayla, one of the students whom I knew well because she
served as an academic liaison between the students and me, broke the
silence.
“I™d buy stocks, I would diversify and try to minimize transaction
costs. Accordingly, I would probably not try to pick individual stocks, but



159
160 Applying Science and Art to Bonds, Stocks, and Real Estate



rather invest through mutual funds. My mutual funds would focus on
companies of all sizes and include some that buy international stocks,”
answered Gayla.
Gayla was a great student, and her answer was textbook. In fact, her
answer is nearly identical to that given by finance guru Professor Jeremy
Siegel of the Wharton School of the University of Pennsylvania. Profes-
sor Siegel™s book Stocks for the Long Run is a comprehensive analysis of
investing. This book has played an important role in changing the way
that Americans invest.
We will review the main statistical findings of Stocks for the Long
Run, but before we do, let™s pose the same question to Professor Siegel.
“If you had $1 million, what would you do with it?” In the last chapter of
his book, Professor Siegel provides his answer.1 In the 1998 edition Pro-
fessor Siegel told investors: “1. Stocks should constitute the overwhelm-
ing proportion of all long-term financial portfolios. . . 2. Invest the largest
percentage”the core holding of your stock portfolio”in highly diversi-
fied mutual funds with very low expense ratios. . . 3. Place up to one-
quarter of your stocks in mid- and small-sized stock funds. . . 4. Allocate
about one-quarter of your stock portfolio to international equities.”
The 20-year old college student gave the same answer as Professor
Siegel. Buy stocks, diversify, and keep expenses low. This is the main
message to investors from many sources.
Conventional wisdom says that if you want to be rich, stocks are the
best investment. In fact, this message has become so ubiquitous that it is
almost a mantra: Stocks are the best investment. Stocks are the best
investment. Stocks are the best investment.
Gayla came through with flying colors and gave the exact same
answer as professionals who make their living advising others on what to
do. How did Peter Borish respond to this answer? He asked, “Do you
drive your car by looking in the rearview mirror?”
When it comes to stocks, Peter™s question is fundamental. U.S. stocks
have had an undeniably bright past. Unfortunately, we are not able to go
back in time and buy stocks in 1982 or even 1802 (the beginning of Pro-
fessor Siegel™s analysis). What is relevant to us is not the past, but the
Stocks 161



future. To understand the prospects for stocks, we have to dissect the past
and see if the sources of past success are likely to continue into the future.



The Big Pile of Stock Market Cash Visible
in the Rearview Mirror

It is not a coincidence that Gayla gave the same answer as Stocks for the
Long Run. Professor Siegel has played a major role in promoting stock
ownership. So much so that it is worth summarizing his main findings.
This section uses the analysis of the second edition of Stocks for the Long
Run, which was published in 1998. This is important for understanding
the cycle of irrationality. This 1998 edition was the one that existed at the
height of the technology bubble. From 1802 through the publication of
the second edition there was one key to making good investments. It was:
To make money as an investor, the correct strategy throughout U.S. his-
tory was to buy U.S. stocks.
Professor Siegel™s work shows the following.

1. Over the course of history in the United States, stocks provided
the best return.
2. For investors with a suitably long-run view, stocks were the
best investment in every period.
3. While buying stocks when they were low (after a crash) would
obviously have been the best strategy, even buying stocks when
they were high (even right before a crash) was a fine strategy.

Let™s look at each of these extraordinary facts (and they are facts) in detail.
Table 8.1 shows that U.S. stocks have left other investments in the dust.
A $1,000 investment in stocks in 1802 would have been worth over $7
billion by 1997! This calculation assumes that all proceeds from owning
the stocks including dividends were used to purchase more stocks. Thus,
stocks were by far the best choice for the 1802 investor.
In contrast, from 1802 to 1997 gold did not even keep pace with
162 Applying Science and Art to Bonds, Stocks, and Real Estate



TABLE 8.1 For 200 Years, U.S. Stocks Have Been Great Investments
Investment of $1000 in 1802 1997 value

U.S. Consumer Price Index $13,370
Gold $11,170
U.S. Government Bonds $10,744,000
U.S. Stocks $7,470,000,000
Source: Stocks for the Long Run, Second edition, p 6



inflation. The investor who exchanged 10 loaves of bread for gold in
1802 would have been able to buy fewer than 10 loaves of bread with that
same gold in 1997. Those who invested in U.S. government bonds could
feel smart compared to the gold bugs. Overall, however, the stock
investor would have been rewarded with close to 1,000 times more
wealth in 1997 than the bond investor.
If you had a time machine and could travel back to 1802, your course
of action would be clear. Buy stocks. This is Professor Siegel™s first
point”stocks have been the best investment. His second finding
addresses the following questions: What if your time machine dropped
you off at some other point in time other than 1802? Should you, for
example, have bought U.S. stocks in 1861, 1914, or 1929?
The answer is that at almost every time in U.S. history the correct
answer is stocks. Obviously, U.S. stocks have declined in many individ-
ual years so some multiyear period is required for a fair comparison. Pro-
fessor Siegel does the calculation for 30-year time periods. This can be
thought of as an appropriate time frame for a person saving for retirement
who begins investing relatively early in his or her career.
The stunning finding: In every 30-year time period, except for 1831 to

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