A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

13

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HANDICAPPING THE
FINANCIAL RACE: A
PRIMER IN
UNDERSTANDING AND
PROJECTING RETURNS
FROM STOCKS AND
BONDS
No man who is correctly informed as to the past will be
disposed to take a morose or desponding view of the present.
—Thomas B. Macaulay, 
History of England

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T
HIS IS THE
chapter where you learn how to become a
financial bookie. Reading it will still leave you unable to
predict the course of the market over the next month or the
next year—no one can do that—but you will be able to better
the odds of constructing a winning portfolio. Although the
price levels of stocks and bonds, the two most important
determinants of net worth, will undoubtedly fluctuate beyond
your control, my general methodology will serve you well in
realistically projecting long-run returns and adapting your
investment program to your financial needs.
WHAT DETERMINES THE
RETURNS FROM STOCKS AND
BONDS?
Very long-run returns from common stocks are driven by two
critical factors: the dividend yield at the time of purchase, and
the future growth rate of earnings and dividends. In principle,
for the buyer who holds his or her stocks forever, a share of
common stock is worth the “present” or “discounted” value
of its stream of future dividends. Recall that this

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“discounting” reflects the fact that a dollar received tomorrow
is worth less than a dollar in hand today. A stock buyer
purchases an ownership interest in a business and hopes to
receive a growing stream of dividends. Even if a company
pays very small dividends today and retains most (or even
all) of its earnings to reinvest in the business, the investor
implicitly assumes that such reinvestment will lead to a more
rapidly growing stream of dividends in the future or
alternatively to greater earnings that can be used by the
company to buy back its stock.
The discounted value of this stream of dividends (or funds
returned to shareholders through stock buybacks) can be
shown to produce a very simple formula for the long-run
total return for either an individual stock or the market as a
whole:
Long-Run Equity Return= Initial Dividend Yield + Growth
Rate.
From 1926 until 2010, for example, common stocks
provided an average annual rate of return of about 9.8

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percent. The dividend yield for the market as a whole on
January 1, 1926, was about 5 percent. The long-run rate of
growth of earnings and dividends was also about 5 percent.
Thus, adding the initial dividend yield to the growth rate gives
a close approximation of the actual rate of return.
Over shorter periods, such as a year or even several years,
a third factor is critical in determining returns. This factor is
the change in valuation relationships—specifically, the change
in the price-dividend or price-earnings multiple. (Increases or
decreases in the price-dividend multiple tend to move in the
same direction as the more popularly used price-earnings
multiple.)
Price-dividend and price-earnings multiples vary widely
from year to year. For example, in times of great optimism,
such as early March 2000, stocks sold at price-earnings
multiples well above 30. The price-dividend multiple was
over 80. At times of great pessimism, such as 1982, stocks
sold at only 8 times earnings and 17 times dividends. These
multiples are also influenced by interest rates. When interest
rates are low, stocks, which compete with bonds for an
investor’s savings, tend to sell at low dividend yields and high
price-earnings multiples. When interest rates are high, stock

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yields rise to be more competitive and stocks tend to sell at
low price-earnings multiples. Common-stock returns were
well below average from 1968 to 1982, when returns were
only about 5½ percent per year. Stocks sold at a dividend
yield of 3 percent at the start of the period, and earnings and
dividend growth was 6 percent per year, a bit above the long-
run average. Had price-earnings multiples (and dividend
yields) remained constant, stocks would have produced a 9
percent annual return, with the 6 percent dividend growth
translated into 6 percent capital appreciation per year. But a
large increase in dividend yields (a large fall in price-earnings
multiples) reduced the average annual return by about 3½
percentage points per year.
A perfectly dreadful period for stock-market investors
was the first decade of the 2000s. The Age of Millennium
turned out to be the Age of Disenchantment. At the start of
April 2000, at the height of the Internet bubble, the dividend
yield for the S&P 500 had fallen to 1.2 percent. (Price-
earnings multiples were above 30.) Dividend growth was
actually very strong during the period, averaging 5.8 percent
per year. Had there been no change in valuation relationships,
stocks would have produced a rate of return of 7 percent (1.2

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percent dividend yield plus 5.8 percent growth). But price-
earnings multiples plummeted and dividend yields rose over
the decade. The change in valuation relationships lopped 13½
percentage points from the return. Hence, stocks did not
return 7 percent—they lost an average of 6½ percent per
year, leading many analysts to refer to these years as “the
lost decade.”
Many analysts question whether dividends are as relevant
now as they were in the past. They argue that firms
increasingly prefer distributing their growing earnings to
stockholders through stock repurchases rather than dividend
increases. Two reasons are offered for such behavior—one
serves shareholders and the other management. The
shareholder benefit was created by tax laws. The tax rate on
realized long-term capital gains has often been only a fraction
of the maximum income tax rate on dividends. Firms that buy
back stock tend to reduce the number of shares outstanding
and therefore increase earnings per share and, thus, share
prices. Hence, stock buybacks tend to create capital gains.
Moreover, capital-gains taxes can be deferred until the stocks
are sold, or even avoided completely if the shares are later
bequeathed. Thus, managers acting in the interest of the

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shareholder will prefer to engage in buybacks rather than
increasing dividends.
The flip side of stock repurchases is more self-serving. A
significant part of management compensation is derived from
stock options, which become valuable only if earnings and the
price of the stock rise. Stock repurchases are an easy way to
bring this about. Larger appreciation benefits the managers by
enhancing the value of their stock options, whereas larger
dividends go into the pockets of current shareholders. From
the 1940s until the 1970s, earnings and dividends grew at
about the same rate. During the last decades of the twentieth
century, however, earnings grew faster than dividends. Over
the very long run, earnings and dividends are likely to grow at
roughly similar rates, and, for ease of reading, I have elected
to do the analysis below in terms of earnings growth.
Long-run returns from bonds are easier to calculate than
those from stocks. Over the long run, the yield that a bond
investor receives is approximated by the yield to maturity of
the bond at the time it is purchased. For a zero-coupon bond
(a bond that makes no periodic interest payments, but simply
returns a fixed amount at maturity), the yield at which it is
purchased is precisely the yield that an investor will receive,

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assuming no default and assuming it is held to maturity. For a
coupon-paying bond (a bond that does make periodic interest
payments), there could be a slight variation in the yield that is
earned over the term of the bond, depending on whether and
at what interest rates the coupon interest is reinvested.
Nevertheless, the initial yield on the bond provides a quite
serviceable estimate of the yield that will be obtained by an
investor who holds the bond until maturity.
Estimating bond returns becomes murky when bonds are
not held until maturity. Changes in interest rates (bond
yields) then become a major factor in determining the net
return received over the period during which the bond is held.
When interest rates rise, bond prices fall so as to make
existing bonds competitive with those that are currently being
issued at the higher interest rates. When rates fall, bond prices
increase. The principle to keep in mind is that bond investors
who don’t hold to maturity will suffer to the extent that
interest rates rise and gain to the extent that rates fall.
Inflation is the dark horse in any handicapping of financial
returns. In the bond market, an increase in the inflation rate is
unambiguously bad. To see this, suppose that there was no
inflation and bonds sold on a 5 percent yield basis, providing

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investors with a real (that is, after inflation) return of 5
percent. Now assume that the inflation rate increases from
zero to 5 percent per year. If investors still require a 5
percent real rate of return, then the bond interest rate must
rise to 10 percent. Only then will investors receive an after-
inflation return of 5 percent. But this will mean that bond
prices fall, and those who previously purchased 5 percent
long-term bonds will suffer a substantial capital loss. Except
for the holder of the inflation-protected bonds recommended
in chapter 12, inflation is the deadly enemy of the bond
investor.
In principle, common stocks should be an inflation hedge,
and stocks are not supposed to suffer with an increase in the
inflation rate. In theory at least, if the inflation rate rises by
one percentage point, all prices should rise by one percentage
point, including the values of factories, equipment, and
inventories. Consequently, the growth rate of earnings and
dividends should rise with the rate of inflation. Thus, even
though all required returns will rise with the rate of inflation,
no change in dividend yields (or price-earnings ratios) will be
required. This is so because expected growth rates should rise
along with increases in the expected inflation rate. Whether

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this happens in practice we will examine below.