most nonexistent,* increased substantially in the 1871 to 1925 period when inflation was low and income taxes were only beginning to come into effect. The bottom line is that from 1945 on, with both higher inflation and income taxes, it was simply no contest. Stocks dramatically enhanced your purchasing power; bonds and T-bills drained it.

A New Investment Era

Stocks outperformed bonds, as Edgar Lawrence Smith, Irving Fisher, and John Maynard Keynes noted as far back as the twenties. However, what comes out in bold face is that inflation and taxes changed the game entirely after the war. Before 1945 stocks had an excellent chance of outperforming T-bills and bonds; now the bet is overwhelming. Just as important, the time required for stocks to outperform fixed-income securities has decreased significantly.

Because the twin horsemen of the apocalypse-inflation and taxes- target debt securities, the probabiUties of stocks outperfonning bonds and T-bills become much higher for shorter holding periods after 1945 than in the previous 145 years. In one year, the odds of stocks outperforming T-bills (after inflation but before taxes) rise from 60% in the pre-1945 worid to 67% after 1945; in a two-year period from 61% to 78%; in 15 years they move from 88% to 92%; and in 20 years they increase from 92% to 100%.

The argument becomes stronger the longer an investor can keep his or her funds in stocks. What is clear is that if you are putting savings away for more than a few years, the major portion should be invested in high-quality stocks. But isnt this more risky? Well look at this question carefully in the next chapter. The answers might surprise you.

Investing in Doomsday

It doesnt happen often, but it happens: the economy of a country disintegrates violently. Sometimes its hyperinflation, sometimes by a crushing military defeat and occupation. How do stocks and bonds cope in these radical situations? In the past 80 years there unfortunately have been enough such occurtences to draw a pretty good picture.

* A 5% federal tax on income over $1,000 was imposed during the Civil War and continued until 1872. The information about how many people bothered to pay Uncle Sam back then is not available.

Lets start with the case of the investor who decided to invest a large amount of money in 1913. The world had been at relative peace for almost a hundred years, with minimum inflation. Being conservative, the investor chose only bonds and, to be fully secure, he piclced only govemment securities. To be extra sure, he went one step further and diversified by buying the obligations of the six strongest powers on Earth.

If he had put them in a safety deposit box inaccessible to him for 10 years, he would have come back to find the bonds of Russia, Austria-Hungary, and Germany valueless, and those of England and France having only a small fraction of their former value because of inflation. Only the bonds of the United States would still possess the greater part of their purchasing power. His assets would have been decimated; yet at the time he made them, the safety of his investments was unquestionably superb. Debt securities failed miserably in this period of major political change and rampant inflation.

Or consider the Weimar Repubhc in Germany after the First Worid War (1919 to 1933). As we all know, this was a classic case of hyperinflation. It took billions of Deutschmarks to buy a loaf of bread. One story is told of a man who loaded a wheelbarrow with Deutschmarks to go to the grocery store. When he came out the wheelbarrow, not the money, was missing. German bonds, once the most gilt-edged securities in Europe, went to nothing. But the German stock market behaved differently. Stocks dropped sharply in the first year of hyperinflation and then began to recover. By 1929, they had entirely regained their purchasing power despite the hyperinflation.

The unconditional surrenders of the Germans and Japanese that ended World War II, followed by the Allied occupations, resulted in a crash of the stocks and bonds of these economies. German stocks plummeted to about a tenth of their former prices, while its bonds became wallpaper. But by the late 1950s the German stock market had regained its previous highs in real purchasing power, and by the early 1980s matched the spectacular increase of the American market since 1925.

The case of Japan was almost identical. By 1945 the Japanese stock market in real terms had dropped well over 90% from its high in the early 1940s. By the late 1980s it had risen about 6,700% from its lows. Japanese bonds, however, adjusted for inflation, fell almost 90% by the end of the war. Fifty years later they still only had 25% of the purchasing power of the early 1940s, despite the countrys miraculous recovery and prosperity. Inflation again.

Brazil, Argentina, and other Latin American countries, as well, have had high inflation for decades. At the beginning of each bout of hyper-

* The new Treasury Bonds first issued in early 1997, which adjust both principal and interest for inflation, change this for tax-free accounts. However from the initial yields at least, it appears the return will still be well below those of stocks over time.

inflation the stock markets turned down for a period, but then raUied to more than offset the ravages of runaway prices.

Why do stocks do so well in these extreme conditions, while the capital of bond holders is dissipated? Land, plants, machinery, equipment, and inventories adjust to their replacement cost in real terms. A company in Germany might have had a value of 1,000,000 Deutschmarks before the hyperinflation, and might have moved to 10 billion afterwards. The real value of the company had not changed.

But, an astute reader might ask, if rising prices adjust only to the value of assets in real terms, why arent gold and precious metals far higher too? The answer is that the productive assets of a company are capable of producing a stream of increasing eamings. A pharmaceutical company trades at many times the worth of its physical assets. The market recognizes this and adjusts the price in the inflated currency to approximate its real worth. Gold and other precious metals only keep up with inflation; they have no growth potential.

The holder of bonds, T-bills, or other fixed income investments has no such protection. Anyone who buys a bond or a T-bill or an annuity is guaranteed the payment of a fixed amount of dollars, marks, or yen. inflation effectively takes capital away-tough. From what weve seen in this chapter these investments look precarious at best.* But remember, this new investment world, where inflation constantly erodes the value of bonds, T-bills, and other fixed income savings, is only a httie over 50 years old. The conventional wisdom of many hundreds of years is that inflation is a nonevent. We might have been amused by tiie 2!% interest the English received on their govemment bonds in the eighteenth and nineteenth centuries. But 2A percent was a reasonable rate of retum in a period of price stability that lasted for centuries.

Too, the conventional wisdom of our time focuses to a large extent on dollar value, not real value. Even today, knowing the terrible toll inflation has taken, the vast majority of fiduciaries, from bank trast departments to money managers, recommend a significant portion of the portfolio be in bonds and T-bills or other short-term investments. A portfolio that is 65% or more in equities and 35% or less in fixed income is considered reasonably aggressive. Fifty to 55% equity and 45 to 50% fixed income is far more the norm. If I were to recommend to the tmstees of a pension fund, whose retirement funds our firm manages, that they put 90% into stocks (knowing they will not need the money for