I think I know what Warren Buffet was trying to say. There has been an equity premium in the capital markets for a long, long time. Stocks have tended to return more than most other asset classes even after adjusting for risk. That equity premium remained in place for so long because most investors didn't even realize that it was there; essentially they thought that stocks would be more risky than they really turned out to be.
Now that the equity premium is more widely recognized and understood, traders have mostly arbitraged it away. So if present trends continue for the next 92 years then stocks may not return much more than bonds, real estate, commodities, etc. (At least not after you adjust for the actual risk.)
This is an interesting area of study, but I don't see how it concludes that bonds should do as well as stocks if the premium is truly arbitraged away. That is, if the premium is really gone, then it seems one should still expect stocks to do better than bonds because they make up a faster part of the economy’s growth curve relative to bonds.
Yes, they are riskier investments. But that is why you buy and hold them for the whole century (or at least as long as you can so the day to day risk smooths out a bit).
I had exactly the same reaction when I got to that part of the letter. I think you can take any trend and extrapolate it into incredulity -- Buffett's career is certainly evidence of this.
This "1900 to 2000" trend people are extrapolating from is a myth. Stocks, as a broad category, have historically not been a great investment. Almost all the gain in that period happened in the last 20 years. If you break equity returns down into all possible 40 year periods returns were lousy.
This is taking the index numbers at face value. Better assessments of returns using good inflation numbers and incorporating tax liabilities make the picture much worse.
http://www.itulip.com/realdow.htm
Finally, the real sample size goes back much farther than 1900. We have good equity price data back into the 18th century. 80% market crashes were common. Overall returns were not good.
Stocks were cheap in 1980. Then they soared in price for 20 years. Now people are slow to realize that period was exceptional. Investing is about "buy low, sell high" not "stick your money in stocks." Stocks are high. The smart money bought commodities in the early 70s, changed to bonds in the early 80s, changed to stocks in the early 90s, and changed back to commodities in the early 2000s. That smart investor has absolutely crushed an equity fixated investor. This isn't rocket science, either. It's not that hard to review asset classes once a decade and figure out what's very cheap and what's expensive.
Looking at this thread, I think it would be very useful to link comments on news.yc to disqus (so they show up on the blog post). I'm sure the disqus guys can do that.
So, on a related note... Google has grown really fast over 5 or so years. Say, 12,385% for the sake of argument. What do you think the chances of this experiencing that PERCENTAGE growth over the next 5 years?
I think his point is-- high percentage growth is easy for small things. It gets harder for big things. Growth curves tend to flatten out.
That being said, I agree with your underlying point: bigger things are harder to move % wise. However, when you consider the overall economy, it isn't as clear cut as Google (and Google isn't that clear cut!). There are so many factors to consider, including population growth, rate of integration of certain populations into the "developed world," resource constraints, innovation growth %, etc. etc.
The Dow should increasingly roughly move at a small multiple of the growth of the global economy. So if one says you shouldn't expect the same returns, one is essentially saying that the global economy is going to slow down as a whole relative to the past century. I just haven't seen any compelling evidence for this claim. Sure, I have seen wild speculation and isolated scenarios, but I have not seen any well-thought out arguments that really attempt to capture all the factors in a probabilistic fashion.
The best evidence I have seen is that developed countries tend to have slower growth rates after a certain point. But this is a recent trend, not universal, and of course not perpetually written in stone.
Growth curves for a single company flatten out because a single company can never be larger than the entire market (and in practice never even close to that large). If Google were to grow indefinitely it will eventually become 100% of the economy, swallowing all other companies and employing everyone, but even at that point it would still grow, but only at the rate the entire economy grows.
Growth for the entire economy is only limited by our abilities to innovate and find resources (both material and human resources). There is no inherent ceiling. The ceiling on a single company (which makes it's growth rate fall off) is imposed when it saturates it's market and can't enter any new markets, the economy as a whole is fueled by the seemingly endless wants of humanity. In essence, there is always a new market for the economy to enter: the next human desire.
In short, the only way there could be a ceiling on the entire economy is if humans stopped wanting new things. Economic growth is supply constrained (supply of resources and innovation), not demand constrained.
The DJIA is not a single "thing" that is subject to the same growth rules as a single organization -- it is just an index of companies. The same properties that allowed the index to grow from 66 to ~11,000 in the 20th century could just as easily allow it to grow by a similar percentage in the 21st century: the absolute value of the index is not relevant (it already accounts for stock splits).
He doesn't seem to be taking into account new markets that might soon exist. We had TV's, space travel, the Internet, Y Combinator and wireless communication in the 1900's alone!
The point wasn't that 2 million is a huge number, but that 5.3% is just as huge. The millions are the eye-catching part, but this looks like an odd way of saying a risk-adjusted 5% return is insane, and 10% (the target for a '90s-era portfolio) is not twice but ten times as insane, in the long run.
Who says you have to invest in Dow Jones' market during the 21st century? I'm sure it wouldn't be hard to get a 5.3% return in a more emerging market like, say, India or China.
An investor who wants the most return with the lowest risk will have a balanced portfolio across many asset classes, which would include both the Dow stocks and India and China in some fashion. That being said, the Dow companies already get a significant % of their earnings abroad. And this % is increasing.
Actually it will be hard to get that kind of return in emerging market stocks for three reasons.
1) Emerging markets tend to be riskier, so if you look at it on a risk-adjusted basis the expected returns don't look as good. What happens to your assets if China has another revolution?
2) As a practical matter, an individual US citizen just can't buy equity in many emerging market companies. Either they aren't listed on US exchanges, or are privately held, or national goverments have ownership restrictions in place. There isn't even much in the way of mutual funds to do it indirectly.
3) The few stocks in the BRIC markets available for direct purchase by individual outside investors have already been bid up to ridiculous levels by dumb money who think they can't afford to be left behind. You may be waiting a very long time to see much significant upside.
I think there are two sides to what Warren Buffett is saying. One side is nonsense, I agree - that he can make a prediction like that based on early trends. The other side, however, which is what I think he actually meant, is that, in fact, predicting from trends is not nearly what it's cracked up to be, and that there is no real guarantee of continued healthy returns from US equities, or even long-term returns to capital that are comparable to the low double-digit returns of the 20th Century. That's a legitimate point.
It is utterly reasonable to argue that past returns are no guarantee of future returns, but if that is the argument he meant to make, he did it exceedingly poorly.
[+] [-] nradov|18 years ago|reply
Now that the equity premium is more widely recognized and understood, traders have mostly arbitraged it away. So if present trends continue for the next 92 years then stocks may not return much more than bonds, real estate, commodities, etc. (At least not after you adjust for the actual risk.)
http://en.wikipedia.org/wiki/Equity_premium_puzzle
[+] [-] jdroid|18 years ago|reply
[+] [-] epi0Bauqu|18 years ago|reply
Yes, they are riskier investments. But that is why you buy and hold them for the whole century (or at least as long as you can so the day to day risk smooths out a bit).
[+] [-] xlnt|18 years ago|reply
[+] [-] byrneseyeview|18 years ago|reply
[+] [-] kingkongrevenge|18 years ago|reply
This is taking the index numbers at face value. Better assessments of returns using good inflation numbers and incorporating tax liabilities make the picture much worse. http://www.itulip.com/realdow.htm
Finally, the real sample size goes back much farther than 1900. We have good equity price data back into the 18th century. 80% market crashes were common. Overall returns were not good.
Stocks were cheap in 1980. Then they soared in price for 20 years. Now people are slow to realize that period was exceptional. Investing is about "buy low, sell high" not "stick your money in stocks." Stocks are high. The smart money bought commodities in the early 70s, changed to bonds in the early 80s, changed to stocks in the early 90s, and changed back to commodities in the early 2000s. That smart investor has absolutely crushed an equity fixated investor. This isn't rocket science, either. It's not that hard to review asset classes once a decade and figure out what's very cheap and what's expensive.
[+] [-] rksprst|18 years ago|reply
[+] [-] webwright|18 years ago|reply
I think his point is-- high percentage growth is easy for small things. It gets harder for big things. Growth curves tend to flatten out.
[+] [-] epi0Bauqu|18 years ago|reply
That being said, I agree with your underlying point: bigger things are harder to move % wise. However, when you consider the overall economy, it isn't as clear cut as Google (and Google isn't that clear cut!). There are so many factors to consider, including population growth, rate of integration of certain populations into the "developed world," resource constraints, innovation growth %, etc. etc.
The Dow should increasingly roughly move at a small multiple of the growth of the global economy. So if one says you shouldn't expect the same returns, one is essentially saying that the global economy is going to slow down as a whole relative to the past century. I just haven't seen any compelling evidence for this claim. Sure, I have seen wild speculation and isolated scenarios, but I have not seen any well-thought out arguments that really attempt to capture all the factors in a probabilistic fashion.
The best evidence I have seen is that developed countries tend to have slower growth rates after a certain point. But this is a recent trend, not universal, and of course not perpetually written in stone.
[+] [-] Xichekolas|18 years ago|reply
Growth for the entire economy is only limited by our abilities to innovate and find resources (both material and human resources). There is no inherent ceiling. The ceiling on a single company (which makes it's growth rate fall off) is imposed when it saturates it's market and can't enter any new markets, the economy as a whole is fueled by the seemingly endless wants of humanity. In essence, there is always a new market for the economy to enter: the next human desire.
In short, the only way there could be a ceiling on the entire economy is if humans stopped wanting new things. Economic growth is supply constrained (supply of resources and innovation), not demand constrained.
[+] [-] neilc|18 years ago|reply
[+] [-] jdroid|18 years ago|reply
[+] [-] etal|18 years ago|reply
[+] [-] hobbs|18 years ago|reply
[+] [-] epi0Bauqu|18 years ago|reply
[+] [-] nradov|18 years ago|reply
1) Emerging markets tend to be riskier, so if you look at it on a risk-adjusted basis the expected returns don't look as good. What happens to your assets if China has another revolution?
2) As a practical matter, an individual US citizen just can't buy equity in many emerging market companies. Either they aren't listed on US exchanges, or are privately held, or national goverments have ownership restrictions in place. There isn't even much in the way of mutual funds to do it indirectly.
3) The few stocks in the BRIC markets available for direct purchase by individual outside investors have already been bid up to ridiculous levels by dumb money who think they can't afford to be left behind. You may be waiting a very long time to see much significant upside.
[+] [-] mynameishere|18 years ago|reply
[+] [-] bkmrkr|18 years ago|reply
[+] [-] admoin|18 years ago|reply
[+] [-] wanorris|18 years ago|reply
[+] [-] bridgetroll|18 years ago|reply
Inigo Montoya: You keep using that word. I do not think it means, what you think it means.
[+] [-] andreyf|18 years ago|reply
[+] [-] t0pj|18 years ago|reply
Timeless WB wisdom.
[+] [-] nazgulnarsil|18 years ago|reply
I'm willing to forgive him the occasional brain fart.