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Bursting the Bubble

ROME: "Get-rich-quick": for thousands of people around the world, that is what investing in the stock market means nowadays. Old people invest their savings and pensions from home computers; young men and women give up working for salaries to seek a big pay-off in the stock options on offer from dot.com firms. Given the global market tumult of the past ten days, examining the historical data about the performance of stock markets is a mandatory sobering experience for investors old and new and everywhere.

In the United States over the past 100 years, investments in stocks delivered an average 6% more than safe investments in short-term government securities. This differential has been quite stable over time, although between 1947 and 1994 it was slightly higher at 8%. The numbers are similar in other countries. In Italy between 1961 and 1994, for example, stock investments brought an average return of around 6% more than investments in treasury securities. Certainly, there have been extraordinary periods, such as the 1950s, when the differential between investing in the stock exchange in Milan and treasury securities climbed to over 22%. But there were also unlucky periods; in the next decade (1961-1970), when the average differential was -2%.

Higher returns mean higher risks. It is as simple as that. If, instead of investing in the Standard & Poor index of 500 largest companies quoted on Wall Street, an investor put his savings in small, and often more innovative, companies (the so-called "small caps"), his return would have gone up in the last 50 years by 6% – i.e. by a mere15% over the return on ultra-safe government securities. But the risks that investor faced would also have doubled, for the volatility of returns on short-term government securities was 3% during the same 50 years, but a whopping 17% for the S&P index, and 30% for small cap stocks.

This 30% figure means that, in any one year, the probability that the return on one's investment was going to be 30% higher than the return on government securities was equal to the probability that it would be 30% lower. Given that in the same period American government securities brought, net of inflation, a little less than 2% return, this means that the return on small cap stocks had the probability, in any given year of delivering a +32% or -28% return. In other words, long-term investments in stocks do yield more than investments in government securities, but the heightened volatility means that decades must pass before we can safely conclude that an average stock investment has indeed brought higher returns.