had stuffed our portfolios full of stocks. In a stock market boom, we are
likely to enjoy high salaries and rising real estate values. If things turn out
less perfectly, we will likely need the money that we have and be glad if
it isnā™t all invested in risky stocks.
Our Love Affair with the
Stock Market Continues
Stocks seem to be close to fairly valued. It is easy to construct scenarios
that make stocks look cheap and similarly easy to imagine worlds where
they are expensive. This balancing of risk and reward is the definition of
My worries about investing in U.S. stocks come not from such funda-
mental analysis but rather from a perspective on emotional cycles. When
financial manias reach the magnitude that we saw in the late 1990s, the
recovery generally requires a period of extreme pessimism. While we
had a significant bear market after the bubble burst, it seems that we
never reached the requisite depths.
The final piece of evidence in this argument is that almost no one
believes it. In fact, I find it hard to believe myself. I began serious stock
purchases in the early 1980s. You could buy fantastic, rapid-growth com-
panies with single-digit PEs. I used to walk around my San Diego apart-
ment hitting the Wall Street Journal with excitement and muttering to
myself, āIt is a historic time to buy stocks.ā I knew that stocks were
Throughout my investing life, stocks have been the best investment.
So much so that I have earned far more from stocks than from wages. All
of my training suggests that stocks cannot be as good an investment now
as they have been throughout my life. Nevertheless, I donā™t really believe
it. Or more precisely, my backward-looking lizard brain simply canā™t get
over the fact that stocks have made me a lot of money.
For those of us who have made money for decades by plowing money
190 Applying Science and Art to Bonds, Stocks, and Real Estate
into stocks, it is extremely tough to kick the habit. The argument against
being completely bullish on U.S. stocks is an argument of cognition
against experience. My lizard brain still tells me to invest everything in
stocks even though my analyses suggest otherwise. With my rational
side, I am able to control my investments, but I canā™t stop my lizard brain
from loving stocks.
Love affairs, whether of the wallet or the heart, share common ele-
ments. In Shakespeare in Love the young playwright falls in love with
cross-dressing Viola de Lesseps (played by Gwyneth Paltrow in her
Academy-Award-winning role). Along their romantic road to an eventual
happy ending, Shakespeare and his love must endure a set of challenges,
including a very public engagement between Viola and Phillip Henslowe
(played by Geoffrey Rush).
Because Violaā™s fiancĆ© is a lord, the whole gang ends up before Queen
Elizabeth. Another lord in the audience asks the Queen how the story will
end. She replies, āAs stories must when loveā™s denied: with tears and a
While we have had some tears in our love affair with stocks, Figure
8.8 shows that there has been no journey away from stocks. Over the 10
years spanning 1994 to 2003, investors have placed an additional $1.5
trillion in long-term equity mutual funds. In the post-bubble world, the
rhetoric surrounding stocks is somewhat tempered but there has been no
movement away from stocks as an investment class. Before stocks repre-
sent outstanding value, I predict there will be many years during which
investors are taking money out of stocks.
It is the 1998 edition of Professor Siegelā™s Stocks for the Long Run,
that proclaims, āStocks are actually safer than bank deposits!ā Of course,
two years after this edition was published, the S&P 500 lost half its value,
and the NASDAQ lost 70% of its value. In the post-bubble, 2002 edition
of Stocks for the Long Run the dust-jacket promotion of stocks being
safer than bank deposits has been removed. Nevertheless, the message
remains the same. In fact, Professor Siegelā™s advice on investment allo-
Net New Cash to Equity Funds ($Bns)
FIGURE 8.8 Americaā™s Love Affair with Stocks Is Not Over
Source: Investment Company Institute, 2004 Fact Book, Table 13
cation is worded identically in both pre- and post-bubble editions,
āStocks should constitute the overwhelming proportion of all long-term
Stocks for the long run is still the conventional wisdom. In their
2004 retirement planner, The Motley Fool website says, āFools opt for
stocks above all else as our vehicle of choice for growth over the long
term.ā (Devotees of the Motley Fool call themselves āfoolsā as a com-
Weā™ve seen that Wall Street still recommends that about two-thirds of
all investments should be in stocks. Furthermore, Americans own histor-
ically high levels of stocks. In a Shakespearean sense, weā™ve had the tears
of a bear market, but we have not had the voyage away from stocks that
generally marks the end of an investment era.
U.S. stocks are still the most loved of all investments. If the most loved
investment proves to be the most profitable, it will be the first time in
investing history. I conclude, in answer to Peter Borishā™s question, that
192 Applying Science and Art to Bonds, Stocks, and Real Estate
buying stocks is indeed driving the financial car by looking in the
I still recommend a significant investment in stocks, not because I
expect them to have higher returns than all other investments, but because
stocks have tax advantages and generally unrecognized advantages as
risk reducers. While I advocate a substantial investment in stocks, I am
far more sanguine about their prospects than Professor Siegel or Wall
Live in Your Home; Make Your
Money at Work
Can We Continue to Make Lots of Money
on Our Homes?
In the late 1980s my friends Peter and Julie paid more than $1 million for
an apartment on Manhattanā™s Central Park West. Their beautiful 4,000+
square foot residence is in a prestigious building and has a view of Cen-
Peter bought the property even though he held negative views on the
economy. Accordingly, I asked, āIf you think the economy is in trouble,
doesnā™t that mean that housing prices will fall? Doesnā™t your doom and
gloom view mean that you will lose money on your home?ā
āMake your money at work and live in your home.ā That was Peterā™s
response to my query. He explained that he expected to continue to make
good money at work, and that he didnā™t really care what happened to real
estate prices. He intended to live in his apartment indefinitely, thus the
ups and downs in valuation were irrelevant.
194 Applying Science and Art to Bonds, Stocks, and Real Estate
Peterā™s ādonā™t expect to make money on real estateā philosophy
seemed reasonable for three reasons.
First, housing appreciation will have its ups and downs. For every buyer
of a house, there must be a seller. Unless sellers are idiots, they should sell
only if the price is fair. Since housing prices sometimes go up a lot, āfairā
requires that housing prices should sometimes go down. Houses are risky
investments and should not be expected to increase continuously. There
should be bear markets in houses. This is predicted by both the rational
(efficient markets hypothesis) and irrational views of markets.
Second, throughout most of history land and home prices have, in fact,
gone up and down. The most obvious U.S. example of a real estate bust
is the dustbowl of the 1930s. But it does not take a depression to hurt land
prices. From 1992 through 2004, for example, Japanese land prices fell
every year and lost almost half their value.1 This severe decline took
place even though Japan remains one of the richest countries in the world
and did not suffer an economic depression.
Third, the theory of comparative advantageā”one of the most impor-
tant theories in economicsā”suggests that most people should make their
money at work and not in real estate. According to an oft-told story, Pro-
fessor Paul Samuelson, winner of the 1970 Nobel Prize in Economics,
was once asked by a physicist to name one idea in economics that is true
and nontrivial. Without hesitation, Professor Samuelson answered ācom-
parative advantage.ā What is this theory, and why does it validate Peterā™s
cautious view of real estate prices?
Comparative advantage, first articulated by David Ricardo in the nine-
teenth century, suggests that we (both as a country and as individuals)
can make the most money by focusing on what we do best.2 In his famous
economics textbook, Professor Greg Mankiw (whom we have met before
and will again in a minute) asks whether Tiger Woods should mow his
own lawn.3 The theory of comparative advantage says that even if Tiger
Woods has an absolute advantageā”meaning that he is better than all
othersā”in lawn cutting, he should spend his time with a golf club in his
hands and not grass clippers.
Real Estate 195
My favorite example of a failure to understand comparative advantage
comes from a 1979 article written by James Fallows about President
Jimmy Carter. Mr. Fallows worked at the White House and would ask for
time on the private tennis courts through President Carterā™s secretary. Mr.
Fallows claims that President Carter himself would schedule the White
House tennis courts. On his request for court time Fallows writes, āI
always provided spaces where he [President Carter] could check Yes or
No; Carter would make his decision and send the note back, initialed J.ā4
(President Carter has denied this.)
Comparative advantage and common sense suggest that even though
President Carter was in a unique position to schedule the courts, his time
would have been better spent elsewhere.
What does comparative advantage have to do with real estate prices?
Most people are not experts in real estate, but are experts at something
elseā”often the work they do for a living. Is it more likely that you will
make money by doing what you have trained for all your life, or in some-
thing you spend a few hours on a year?
The answer seems as clear as the fact that Tiger Woods should not
mow his own lawn and Jimmy Carter should not schedule tennis courts.
Those of us who are not real estate specialists should expect to make our
money in the area where we are expertsā”at work. This provides the con-
nection between Peterā™s enigmatic comment and economic theory. We
should expect to make our money where we have a comparative advan-
tage (in our jobs) and not where we are comparative neophytes (in our
So how did Peter do in his work and with his real estate investment?
His outcome was exactly the opposite of that predicted by the theory of
comparative advantage. Peter has done fine at work, but even better in his
home. Peterā™s real estate investment has soared in value and has
increased his net worth by millions of dollars. So Peter actually lived in
his home and made his money in his home!
Both economic theory and historical experience suggest that Peter was
right to seek shelter in his home and profits in his paycheck. His actual
196 Applying Science and Art to Bonds, Stocks, and Real Estate
outcomeā”making more money in real estate than in incomeā”is similar
to that of many Americans.
In fact, Americans have come to rely on the housing market for finan-
cial gain. While the stock market has gone nowhere for almost half a
decade, housing prices have steadily increased. Accordingly, U.S. real
estate values are at all-time highs both in pure dollar terms and also as a
percentage of our wealth.5
Can we continue to both live in and profit from our homes? Can we
continue to make our money where we donā™t have a comparative advan-
tage? Alternatively, is it likely that home prices will stabilize or even
The Harvard Economist versus
the Gutsy Immigrant