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Investment Theory in Practice

Although past performance is never a guarantee of future results, it remains the case that stock-market valuations tend to outstrip bonds most of the time. Still, arriving at the best investment strategy is about more than simply doing the math; it also requires an appreciation of history and tail risks.

BERKELEY – Suppose that you had invested your wealth in a broadly diversified set of stocks, starting in January 1871, with the dividends being rolled back into your portfolio, and with your portfolio being rebalanced every January to maintain diversification. If you had also paid no taxes and incurred no fees, you would have had 65,004 times your initial investment, as of this past January. By contrast, if you had performed the same experiment with long-term US Treasury bonds, you would have only 41 times your initial wealth. That is the difference between an average annual inflation-adjusted return of 7.3% for stocks and 2.5% for bonds – 4.8 points per year, or what Rajnish Mehra and Edward C. Prescott called the “equity premium puzzle.”