1. Chapter 5: stock & bond returns since 1802

2. Total Nominal Returns and Inflation 1802–2012
TOTAL ASSET RETURNS
Total Nominal Returns and Inflation 1802–2012

3. THE LONG-TERM PERFORMANCE OF BONDS

4. GOLD, THE DOLLAR AND INFLATION
U.S. and U.K. Consumer Price Index 1800–2012
Over the past 200 years, customer prices in the united states and the united kingdom has greatly changed. These change (inflation) can be explained by the change in the monetary standard.

5. Gold standard: the price of gold and the price level were closely linked during the 19th and 20th centuries.
Paper money standard : from the depression through world war two, the world shifted to the paper money standard.
Gold prices fell when inflation was brought under control but rose again after the financial crisis.

6. TOTAL REAL RETURNS
The effect of long term investors should be the creation of wealth adjusted for the effect of inflation.
Even if the economy is not growing at all, capital will receive a positive return because it is a scarce resource.

7. Long term stability of stock returns has persisted despite changes in the society.

8. What is Fixed-Income?
Fixed income is a type of investment in which real return rates or periodic income is received at regular intervals and at reasonably predictable levels.
Fixed-income investments can be used to diversify one's portfolio, as they pose less risk than equities and derivative investments.
Retired individuals typically tend to invest heavily in fixed-income

9. As Table 5-2 indicates, the real return on Treasury bills has dropped precipitously from 5.1 percent in the early part of the nineteenth century to a bare 0.6 percent since 1926, a return only slightly above inflation.
The real return on long-term bonds has shown a similar, but more moderate, decline. Bond returns fell from a generous 4.8 percent in the
first subperiod to 3.7 percent in the second and then to only 2.6 percent in the third. The decline in real yield on government bonds over time can
be partly explained by certain factors that boosted their demand: the greatly improved liquidity of bonds and the fact that these bonds satisfy
many fiduciary requirements that other fixed-income assets do not.
These demand-boosting factors raised the prices of government bonds and therefore reduced their yields. The real returns on longer-term
bonds were also reduced by the unexpected inflation that investors experienced in the post–World War II period.

10. The decline in real yield on government bonds:
These demand-boosting factors raised the prices of government bonds and therefore reduced their yields.
Demand is increase
improved liquidity of bonds
Satisfy many fiduciary requirements
fixed-income assets do not
---The real returns on longer-term bonds were also reduced by the unexpected inflation that investors
experienced in the post–World War II period.

11. The short-run volatility of stock returns:
is not unexpected
the volatility of the real returns on government bonds is also quite large
from 1946 through 1981, the real return on Treasury bonds was negative
coupon on the bonds did not offset the decline in bond prices brought about by rising interest rates and inflation.

12. Real returns on bonds
Since The decline in real returns on bonds would have been much greater if it were not for the stellar bond returns of the past three decades.
Since the decline in inflation and interest rates has pushed bond prices upward and greatly improved bondholder returns.
In fact, for the entire three decades that followed the peak in bond yields in the early 1980s, bond returns virtually matched those of equities.
The decline in real returns on bonds since 1926 would have been much greater if it were not for the stellar bond returns of the past three
decades. Since 1981, the decline in inflation and interest rates has pushed bond prices upward and greatly improved bondholder returns.
Although bond returns fell well short of equities during stocks’ mega bull market from 1981 through 1999, bonds easily outpaced stocks in the
following decade. In fact, for the entire three decades that followed the peak in bond yields in the early 1980s, bond returns virtually matched
those of equities.

13. THE CONTINUING DECLINE IN FIXED-INCOME RETURNS
the U.S. Treasury introduced TIPS, or Treasury inflation protected securities
(Fixed-income investors who live on set amounts of periodically paid income face the risk of inflation eroding their spending power. To protect a portfolio from inflation, an investor can purchase Treasury Inflation-Protected Securities (TIPS).
spectacular bond returns cannot continue
These characteristics have provided opportunities for an improved efficient frontier.
TIPS have had relatively small return correlations across various asset classes. Thus, real return portfolios have the potential to enhance the risk-return trade-off for equity-debt portfolios. TIPS can be used effectively within a portfolio containing equities due to low absolute return volatility, small return correlations with equities, and the possibility of an active manager adding value.
TIPS have exhibited smaller return volatilities than similar maturity Treasuries. The smaller TIPS return volatility is a result of lower real yield volatilities. In turn, lower TIPS return volatilities require the use of effective duration as the standard of comparison between TIPS and similarly rated conventional debt, such as Treasuries. We derive TIPS effective durations by adjusting real yield durations by a “yield beta,” which incorporates the expected relationship between real yield and conventional yield movements. This yield beta will vary depending on where we are in the business cycle, but it is less than 1.0. This means that longer-term TIPS can be substituted for shorter-term Treasuries without changing the effective duration of the portfolio.
Low effective durations and price protection through inflation adjustments make TIPS a valuable asset class within a portfolio context. TIPS can be used more effectively than conventional bonds in customizing portfolio risk-return profiles.
Common portfolio risks and objectives can be actively and effectively managed using TIPS investments:
The need to fund requirements that are inflation-sensitive or are stated in real terms
The desire to narrow return dispersion over an investment horizon or lock in an existing surplus
The risk-to-equity returns and volatility in an inflationary environment

14. The coupons and principal from these bonds, backed by the full faith and credit of the U.S. government, are linked to
the U.S. consumer price index, so that the yield on these bonds is a real, inflation-adjusted yield, shown in Figure 5-5.
The steady decline in the yields on these bonds is readily apparent. When these bonds were first issued, their yield was just short of 3.5 percent.
That is almost identical to the historical real return on government bonds that I had found in my research analyzing data dating from 1802.
After issuance, the yield on TIPS increased, reaching a high of 4.40 per-cent in January 2000, the month that also marked the peak of the tech
and Internet bubble. From that date, the yield on TIPS began a relentless decline. From
2002 through 2007 the yield fell to 2 percent. As the financial crisis deepened, the yield continued to decline and sank below zero in August
2011, reaching nearly –1 percent by December This negative real yield was similar to the implied after-inflation yields on the standard
Treasury bonds. The yield on the 10-year Treasury bond fell to a 75-year low of 1.39 percent in July 2012, well below the ongoing and forecast
rate of inflation.

15. Real yield on Treasury bonds
determined:
state of the economy
fears of inflation
risk attitudes
of investors
economic growth
The real yield on Treasury bonds is determined by many factors, such as the state of the economy, fears of inflation, and the risk attitudes
of investors. But in almost all economic models, the most important factor influencing the real return on bonds is economic growth. Indeed, the
3.4 percent yield set at the first TIPS auction was almost exactly equal to real GDP growth in the 1990s. As real economic growth slowed to about
2 percent from 2002 through 2007, the yields on TIPS fell accordingly. But no forecaster in 2012 predicted real economic growth over the
next decade would be negative, as the yield on TIPS suggested. Only extreme risk aversion can explain why investors were willing to accept
negative after-inflation returns on government bonds even though other assets, such as equities, have consistently delivered long-term real
returns of 6 to 7 percent per year.

16. Equity Risk Premium
Equity risk premium has averaged 3% for US Treasury bonds and 3.9% for Treasury bills over the past 215 years.
Equity risk premium has shrunk to zero for long-dated US Treasury bonds since

18. Why has the equity risk premium shrunk to zero since 1980?

19. Is this phenomenon unique to the us?

20. Real equity returns ranged from 1.7% (Italy) to 7.2% (Australia and S. Africa)
Countries with lower real equity returns had lower fixed-income returns. (F.I. returns in Italy, Belgium, France, Germany and Japan were negative).
Countries with the more liberal market policies had asset classes that tended to perform better than those in countries with less liberal market policies.
In 215 years, annual returns on common stock have ranged between 6 and 7 % in the US.
Wars, financial crises, political crises and natural disasters have periodically disrupted this long-term upward trajectory. However, economic fundamental forces have always enabled equities to regain their long-term trend.