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100 management. In 1830, Justice Samuel Putnam of the Massachusetts Supreme Court rendered the decision that was to serve as the critical guideline for management of money for over 130 years. He said in part: All that can be required of a trustee to invest is that he conduct himself faithfully and exercise a source of discretion. He is to observe how men of prudence and intelhgence manage their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of the capital to be invested. Thus was bom the famous "prudent man mle" defining the responsi-bihties of a tmstee handling funds for others. It was the cornerstone of American fiduciary practice until well into the 1970s, and is still an important guideline for the courts today. Before 1945, as we have seen, witii a few brief exceptions, inflation was not a serious problem in this country. The pmdent man might be expected to stay primarily in bonds and Treasury bills with small amounts of income-yielding common stocks and revenue-producing real estate. A dollars a dollar, this line of thinking ran. The bank or insurance company, and most other fiduciaries, were considered to have fulfilled their obligations to their chents by keeping the principal intact in dollar terms, not in terms of purchasing power. But as we know, there has been a radical change in the real value of the dollar since the Second World War. Todays dollar has only a sliver of the purchasing power it had in 1802. Peoples perceptions and the law often lag behind changing conditions by decades. Thus the preservation of capital in dollars, rather than in purchasing power, is still viewed as the fiduciarys major responsibility. The focus on the dollar itself, not on what it can buy, is the backbone of the bond market, bank accounts, life insurance policies, and scores of other financial products. If taken to court, most fiduciaries would probably still win today if they had preserved their clients dollars, no matter how much the purchasing power had shmnk. Investors forget, or still have not leamed, how destmctive inflation and taxes are to their fixed income investments. The magic of compound interest makes it appear so easy-and riskless-particularly if you buy U.S. govemment securities, supposedly the safest investment around.
Are Stocks More Risky? The wisdom of the ages has always been that bonds are less risky than stocks over time. Bondholders of a company, after all, had far less financial risk than the shareholders. If a company ran into financial problems it could cut its dividend to shareholders, but it had to maintain interest payments and repay the bond principal when it was due. Otherwise, the company was in default and the creditors got everything the company owned before the shareholders got a penny. A large company like a railroad would have many classes of debt securities. These range from first mortgage, to second mortgage, to debentures. The holders of the first mortgage securities were entitled to every dollar they were owed before the second mortgage holders got anything, and so on. Preferred shares were a hybrid that paid more than bonds, but stood behind all debt holders in the schedule of repayment in case of financial difficulty. Graham and Dodd devoted a large part of their book to how to analyze the bonds and debentures of companies, as did many other serious * With the exception of some calamitous event such as the Great Depression. Toward a Realistic Definition of Risk We have seen that risk, as the academics defined it, was eventually rejected by efficient market types themselves. Higher volatility did not provide the promised higher retums, nor lower volatility lower results. This leads us back to square one. We can now constmct a more sensible theory of risk measurement, one that takes into account the pitfalls you face today. As noted in the last chapter, an all-encompassing strain of risk permanently entered the investment environment for the first time after World War II. The vimlent new risk is called inflation. Nothing is safe from this vims, although its major victims are savings accounts, T-bills, bonds, and other types of fixed-income investments. For these investments, there is no antidote. While a relatively small number of companies may flounder financially or go under in any normal period, credit risk is far less dangerous than inflation risk.* And govemment bonds or T-bills eliminate credit risk entirely. Not so for inflationary risk. Inflationary pressures after the Second World War have radically and completely altered the retum distributions of stocks, bonds and T-bills.
students of security analysis of the period. Writing in the thirties, the major risk investors had to face was financial. The risk of inflation was an insignificant concem at that time. The rapid inflation of the postwar period has tumed all risk calculations topsy-turvy. While stocks have always had higher retmns than T-bills or bonds over time, as we saw in the last chapter, the disparity between the three classes of financial investment widened enormously after 1945. Since the Second World War, moreover, cumulative stock retums, adjusted for inflation, have moved exponentially higher than T-bills or bonds for periods of 15 years or more. Inflation destroys the retums of T-bills, govemment bonds, and all other debt securities. Yet few investors put this enormous outperformance of stocks over debt securities into their risk calculations. Table 14-1 shows the inflation-adjusted retums of stocks, bonds, and T-bills for periods of 1 to 30 years in the postwar period. As the table indicates, the longer the holding period the greater the differences. The first row in column 1 demonstrates that stocks provided a 7.5% annual retum on average over the entire period after inflation. At the end of 5 years, capital youve invested in stocks increased 44%, more than doubling after 10 years, and almost nine-folding after 30. With govemment bonds and T-bills the rate of increase moves up at a snails pace. After 10 years, bonds (column 2) expand your initial capital by only 9%, after 30 years by only 29%. The rate of increase for T-bills is lower yet (column 3). After a decade, adjusted for inflation, your capital would have increased 4%, after two decades by 9%. Table 14-1 Compounded Returns After Inflation 1946-1996 Holding Portfolio for... | | Retums | | Percent of times stocks beat | Stocks | Bonds | T-bills | Bonds | T-bills | 1 year | 7.5% | 0.9% | 0.4% | | | 2 years | 15.6% | 1.7% | 0.9% | | | 3 years | 24.3% | 2.6% | 1.3% | | | 4 years | 33.6% | 3.5% | 1.7% | | | 5 years | 43.7% | 4.4% | 2.1% | | | 10 years | 106.5% | 9.0% | 4.3% | | | 15 years | 196.7% | 13.8% | 6.5% | 100% | | 20 years | 326.3% | 18.8% | 8.8% | 100% | 100% | 25 years | 512.6% | 24.0% | 11.1% | 100% | 100% | 30 years | 780.3% | 29.4% | 13.5% | 100% | 100% |
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