the risk and return on stocks and bonds are not physical constants, like
the speed of light or gravitational force, waiting to be discovered in the
natural world. Despite the overwhelming quantity of historical data,
one can never be certain that the underlying factors that generate asset
prices have remained unchanged. One cannot, as in the physical sci-
ences, run repeated controlled experiments, holding all other factors
constant while estimating the value of the parameter in question. As
Nobel laureate Paul Samuelson is fond of saying, “We have but one sam-
ple of history.”
Yet one must start by analyzing the past in order to understand the
future. The first chapter showed that not only have fixed-income returns
lagged substantially behind those on equities but, because of the uncer-
tainty of inflation, bonds can be quite risky for long-term investors. In
this chapter one shall see that because of the changing nature of risk over
time, portfolio allocations depend crucially on the investor’s planning
horizon.
RISK AND HOLDING PERIOD
For many investors, the most meaningful way to describe risk is by por-
traying a “worst-case scenario.” The best and worst after-inflation re-
turns for stocks, bonds, and bills from 1802 over holding periods
ranging from 1 to 30 years are displayed in Figure 2-1. Here stock returns
are measured by dividends plus capital gains or losses available on a
broad capitalization-weighted index of U.S. small and large stocks.
Note that the height of the bars, which measures the difference be-
tween best and worst returns, declines far more rapidly for equities than
for fixed-income securities as the holding period increases.
Stocks are unquestionably riskier than bonds or Treasury bills over
one- and two-year periods. However, in every five-year period since
1802, the worst performance in stocks, at –11 percent per year, has been
only slightly worse than the worst performance in bonds or bills. And
for 10-year holding periods, the worst stock performance has actually
beenbetterthan that for bonds or bills.
For 20-year holding periods, stock returns have never fallen below
inflation, while returns for bonds and bills once fell as much as 3 percent
per year below the inflation rate for two decades. This wiped out almost
one-half the purchasing power of a bond portfolio. For 30-year periods,
the worst returns for stocks remained comfortably ahead of inflation by
2.6 percent per year, a return that is not far from the averagereturn on
fixed-income assets.
24 PART 1 The Verdict of History