Factors That Impact Expected Returns
We have shown in Chapter 5 that the reduction in taxes on equity return
due to the reduction in marginal and capital gains tax rates and inflation
have added more than 2 percentage points to the return over the last half
century. This is substantially more than the increase in the after-tax re-
turn on fixed-income assets.
But there has been a second significant factor increasing expected
return on stocks—the reduction in transactions costs. Chapter 1 con-
firmed that the real return on equityas measured by stock indexeswas near
7 percent in the nineteenth and twentieth centuries. But over the nine-
teenth century and the early part of the twentieth century, it was ex-
tremely difficult, if not impossible, for an investor to replicate the stock
returns calculated from these stock indexes.
Charles Jones of Columbia University has documented stock trad-
ing costs over the last century.^10 These costs include both the fees paid to
brokers and the “bid-asked spread,” or the difference between the buy-
ing and selling costs for stocks. His analysis shows that the average one-
way cost to either buy or sell a stock has dropped from over 1 percent of
value traded as late as 1975 (before the deregulation of brokerage fees) to
under 0.18 percent today.
The fall in transactions costs suggests that the price of obtaining
and maintaining a diversified portfolio of common stocks, which is nec-
essary to replicate index returns, could have easily cost from 1 to 2 per-
cent per year over much of the nineteenth and twentieth centuries.
Because of these costs, investors in earlier years purchased fewer stocks
than in an index and were less diversified, thereby assuming more risk
than implied by stock indexes. Alternatively, if investors attempted to
buy all the stocks, their real returns could have been as low as 5 percent
per year after deducting transactions costs.
The collapse of transactions costs over the past two decades means
that stockholders can now acquire and hold a completely diversified
portfolio at an extremely low cost.^11 It has been well established that liq-
uid securities—that is, those assets that can be sold quickly and at little
cost on short notice in the public market—command a premium over
illiquid securities. Through most of the past two centuries, stocks were
far less liquid than today, and therefore they were sold at a significantCHAPTER 8 The Impact of Economic Growth on Market Valuation and the Coming Age Wave 129
(^10) Charles M. Jones, “A Century of Stock Market Liquidity and Trading Costs,” working paper, May
23, 2002.
(^11) The cost of some index funds for even small investors is only 0.1 percent per year. See Chapter 20.