The Historical Record

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Roger Ibbotson and Rex Sinquefield conducted a famous set of studies dealing with rates of return in U.S. financial markets.2 They presented year-to-year historical rates of return on five important types of financial investments. The returns can be interpreted as what you would have earned if you had held portfolios of ihe following:

1. Large-company stocks. The large-company stock portfolio is based on the Standard & Poor's 500 index, which contains 500 of the largest companies (in terms of total market value of outstanding stock) in the United Slates.

" R. G. Ibbotson and R. A. Sinquefield. Sun k*. Boiuk. Rills, and Inflation 1SBB1J (Charlottesville. VA: Financial Analysis Research Foundation. ISI82).

2. Small-company stocks. This is a portfolio composed of stock of smaller companies, where "small" corresponds to the smallest 20 percent of the companies listed on the New York Stock Exchange, again as measured by market value of outstanding stock.

3. Long-term corporate bonds. This is a portfolio of high-quality bonds with 20 years to maturity.

4. Long-term U.S. government bonds. This is a portfolio of U.S. government bonds with 20 years to maturity.

5. U.S. Treasury bills. This is a portfolio of Treasury bills (T-bills for short) with a three-month maturity.

These returns arc not adjusted for inflation or taxes; thus, they are nominal, pretax returns.

In addition to the year-to-year returns on these financial instruments, the year-to-year percentage change in the consumer price index (CPI) is also computed. This is a commonly used measure of inflation, so we can calculate real returns using this as the inflation rate.

A First Look

Before looking closely at the different portfolio returns, we take a look at the big picture. Figure I0.4 shows what happened to SI invested in these different portfolios at the beginning of 1926. The growth in value for each of the different portfolios over the 81-year period ending in 2006 is given separately (the long-term corporate bonds are omitted). Notice that to get everything on a single graph, some modification in scaling is used. As is commonly done with financial series, the vertical axis is scaled such that equal distances measure equal percentage (as opposed to dollar) changes in values.

Looking at Figure 10.4. we see that the small-company, or "small-cap" (short for small-capitalization), investment did the best overall. Every dollar invested grew to a remarkable SI 5,922.43 over the 81 years. The larger common stock portfolio did less well: a dollar invested in it grew to $3,077.33.

At the other end, the T-bill portfolio grew to only SI 9.29. This is even less impressive when we consider the inflation over this period. As illustrated, the increase in the price level was such that SI 1.26 is needed just to replace the original $l.

Given the historical record, why would anybody buy anything other than small cap stocks? If you look closely at Figure I0.4, you will probably see the answer. The T-bill portfolio and the long-term government bond portfolio grew more slowly than did the stock portfolios, but they also grew much more steadily. The small stocks ended up on top, but, as you can see, they grew quite erratically at times. For example, the small stocks were the worst performers for about the first 10 years and had a smaller return than long-term government bonds for almost 15 years.

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A Closer Look

To illustrate the variability of the different investments. Figures 10.5 through 10.8 plot the year-to-year percentage returns in the form of vertical bars drawn from the horizontal axis. The height of the bar tells us the return for the particular year. For example, looking at the long-term government bonds (Figure 10.7). we see that the largest historical return (40.35 percent) occurred in 1982. This was a good year for bonds. In comparing these

A $1 investment in different types of portfolios: 1925-2006 (Year-end 1925 = S1)

A $1 investment in different types of portfolios: 1925-2006 (Year-end 1925 = S1)


Source: Slocks, Bonds, Biffs, and Inflation YearbookIbbolson Associates, Inc., Chicago (annually updates work by Roger 6. Ibbotson and Rex Slnquefield) All rights reserved-


Source: Slocks, Bonds, Biffs, and Inflation YearbookIbbolson Associates, Inc., Chicago (annually updates work by Roger 6. Ibbotson and Rex Slnquefield) All rights reserved-

charts. notice the differences in the vertical axis scales. With these differences in mind, you can see how predictably the Treasury bills (Figure 10.7) behaved compared to the small stocks (Figure 10.6).

The returns shown in these bar graphs are sometimes very large. Looking at the graphs, we see, for example, that the largest single-year return was a remarkable 143 percent for

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