Investor Behavior: The Common Stock Legend and Mutual Funds
Mutual Funds and the Common Stock Legend
The Common Stock Legend
Throughout the 19th century, common stock was considered a speculative investment. In 1830, Harvard College sued a Mr. Amory, trustee, for having invested university funds in common stock.
Bonds were considered to be the safest investment for over one hundred years.
The outcome of this case was the prudent man rule and the idea that a diversified and carefully selected portfolio of common stock could indeed be considered a wise application of funds.
Nevertheless, bonds continued to be viewed as the safest investment for the next one hundred years.
It was only after the Great Depression and the retreat from the gold standard that risk of inflation motivated investors to shift from bonds to equities.
The Golden Age of Dividends
For over one hundred and fifty years, dividend yield on common stock was usually higher than the yield on investment grade bonds.
At mid-century, insurance companies found that dividend yields on common stock were 180% of the return on bonds.
In the mid-sixties, the Life Insurance Associations of America made a study of investment portfolios of large insurance companies and found that in a recent thirty-year period, the weighted average dividend yield of common stock in life insurance portfolios was 5.79%, compared to 3.17% on bonds.
When capital gains were added, common stocks showed a return of 7.56%, compared to 3.27% on bonds. These figures confirmed other studies showing the superior returns of common stock.
The insurance study revealed that three quarters of historical returns on common stock came from cash dividends, and only one-fourth of total return was due to an increase in market value.
How We Came to Love Common Stocks
The arguments in favor of common stock were simple and compelling:
High Cash Returns
High-grade common stock paid cash dividends that were generally higher than the interest paid on bonds.
Therefore, as long as a company was sound, common stock provided greater cash income than bonds, even if prices fell. Fluctuations in stock prices were not a major concern to long term investors who sought reliable income;
Inflation Hedge
Unlike bonds, the dividends on common stock increased as the profits of the company increased, and since companies could raise prices to match costs, this provided a hedge against inflation;
Ownership Rights
Common stocks represented an owner's claim against the land, equipment, and factories of issuers;
Diversification
Like bonds, risks on individual stocks could be reduced through diversification.
It took generations for stocks to overcome the speculative stigma and become an accepted long-term investment for conservative institutions and the public.
Most of the theory of common stock investment was developed during years when historical analysis showed that stocks paid higher cash yields than bonds and when investments flowed in the traditional direction — from investors to corporations.
In 1912, Professor Irving Fisher wrote papers indicating that common stocks offered a shield against inflation.
Graham and Dodd published Securities Analysis in 1937, describing a technique for selecting stocks based on intrinsic value and common sense.
John Burr Williams wrote Evaluation of the Rule of Present Worth in 1938, explaining how the discounted present value of dividends could be used to determine the value of equities.
The Rise of People's Capitalism
In 1954, the New York Stock Exchange began a campaign to promote equity ownership with the slogan, Own a Share of America.
This campaign urged the public to buy shares not only for their retirement and for the education of their children but also as a patriotic duty.
In 1952, only 4.2% of Americans owned stocks.
When the New York Stock Exchange launched this campaign, few Americans owned stock. In 1952, the Brookings Institution estimated that only 4.2% of the population held equity.
The New York Stock Exchange's 1954 survey counted only 7.5 million American shareholders.
Throughout the fifties and sixties, many firms promoted equity mutual funds through door-to-door sales, covering heavy marketing costs with front-load commissions.
Merrill Lynch, the largest retail broker, although it shunned mutual funds for decades, had its own "shareholder democracy" campaign, seeking to bring Wall Street to Main Street.
A Marketing Triumph
During two generations, persistent marketing convinced seventy million Americans to buy shares.
The Investment Company Institute and the Securities Industry Association's 1999 shareholder census showed that half of American households and over seventy-eight million investors owned stock.
By the 21st century, half of U.S. households owned stock.
By the millennium, equity ownership was widespread and shareholder democracy resonated in Washington, although most Americans had portfolios worth less than twenty-five thousand dollars and fewer than seven stocks.
Ordinary Americans bought stock for the long-term, mainly for retirement or education and usually through mutual funds or tax deferred savings plans.
Most investors admitted that they had only an elementary understanding of the market, relying instead on the guidance of professionals.
For more than a generation, stock prices increased faster than inflation. Until the first quarter of 2000, the advice of experts had proved correct and investors were happy.
Investing on Auto-Pilot
By the 1980s, millions of Americans were investing in stock through equity mutual funds, payroll deductions, and tax-deferred 401(k) plans.
Often there were multiple fiduciaries between the investor and the corporate executive that managed their assets.
Stockholders became separated from issuers by multiple layers of fiduciaries.
In the case of 401(k) plans, there are ordinarily five layers of fiduciaries between investors and corporate executives:
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the plan administrator;
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the plan trustees;
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fund directors;
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fund managers; and
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corporate directors.
By 2004, average Americans, investing in equities through 401(k) plans had no idea of what stocks they owned. Individual holdings were so reduced through diversification as to be almost irrelevant.
The SEC had loosened requirements for disclosure of fund portfolios. It was now possible that small investors would never see their portfolios.
From Real Money to Total Returns
In the 1950s the average investor was smart enough to realize that the purpose of stock investment was to purchase a stream of dividends that provided a yield higher than the yield on bonds.
By the year 2000 this commonsense view had been replaced by the idea of total returns.
Mutual fund marketers promoted unrealized capital gains and paper profits.
Mutual funds promoted annual performance in terms of realized and unrealized capital gains, along with cash dividends.
For the investor in 401(k) funds, with money tied up for fifteen to twenty years, annual unrealized capital gains were almost completely irrelevant in assessing the assets that she might have upon retirement.
The SEC permits mutual funds to avoid disclosure of data that might inform investors as to intrinsic value of their holdings.
Few funds reveal the weighted average price-earnings ratios, average dividend payout ratios, average dividend coverage, or other measures than might indicate long-term value.
A fund manager's emphasis is almost entirely on short-term capital gains (realized on not) and short-term price volatility, numbers that may make naive investors feel good, but that do not provide any clue about the resources they will have upon retirement in fifteen or twenty years.
Economists and the Common Stock Legend
Wall Street has promoted the Common Stock Legend since the 1950s, by claiming that:
Regular savings in diversified portfolios of common stocks, such as mutual funds, if maintained over many years, through highs and lows in stock prices, will always lead to an increase in real wealth greater than any investment alternative.
When initially promulgated, this investment strategy made sense, since stocks yielded higher cash returns than bonds and the relatively small segment of the population that bought stocks, did so directly based on commonsense evaluation of the issuers.
In the first half of the century, economists such as Irving Fisher and John Burr Williams recommended common stocks, based on reasonable concepts of intrinsic value.
However, as the century wore on and as more and more investors bought stocks indirectly through funds, several things happened:
As the median intelligence of investors declined, economists got in bed with Wall Street.
- The median intelligence of investors in common stock declined, as the percentage of the population investing increased from less than 5% to over 50%. This increase in unsophistication was the natural consequence of the Bell Curve.
- Economists, such as Harry Markowitz and John Maynard Keynes, promoted the idea that the object of stock investing was capital gains.
- Markowitz defined risk as short-term volatility in price, rather than the long-term reliability of dividends. This gave respectability, if not wisdom, to the idea of judging performance in terms of total return.
- Other economists, such as Eugene Fama and Burton Malkiel, promoted the Efficient Market Hypothesis, saying essentially, that stock prices, no matter how high, were always correctly valued.
- This implied that investment in non-managed index funds was prudent. Until the 1990s, average prices of common stock oscillated between ten and twenty times earnings for over one hundred years.
- With the help of the Efficient Market Hypothesis, extreme price levels during the Great Bubble of the 1990s were justified by the high priests of economics.
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Thousands of economists of lesser fame, got into bed with Wall Street and published articles and gave interviews in the popular and ever-expanding investment media (such as Money magazine), declaring the Common Stock Legend to be absolutely true.
- Their proof was generally based on the long-term appreciation of stock indices, such as the S&P Industrials.
- These indices are misleading indicators of long-term investment returns, because failed companies are eliminated at no cost and because the logic of projecting price trends is faulty.
- See graph on the St. Petersburg Stock Exchange. Most companies in the S&P average of ninety years ago no longer exist.
The Common Stock Legend, throughout the last half of the 20th century, was spurred on an ever-growing crowd of increasingly unsophisticated and tuned-out investors that blindly and regularly sent part of their paycheck to buy equity mutual funds, while the SEC looked the other way.
This hoard of innocents made easy pickings for massive deception by corporate executives that used stock buybacks to keep Wall Street happy, while giving value to their stock options.
When studying the flow of funds tables for Mutual Funds, it is well to keep the Common Stock Legend in mind.
Before proceeding, check your progress:
Self-Test
Throughout most of the history of the American stock market:
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In 1952, what percent of the American population owned common stock?
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In the year 2000, most American investors in the stock market:
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learning module : continued >
| "Common Stocks and Uncommon Profits and Other Writings", Paperback, Phillip A. Fisher, Kenneth L. Fisher
Fisher is one of the pioneers in promoting common stock investment. His ideas are regarded as gospel by many investors. This classic, first published in 1958, indicates the origins of the Common Stock Legend. |
| "Irving Fisher: A Biography", Hardcover, Robert Loring Allen
Considered by some to be the greatest American economist, Irving Fisher promoted common stocks as early as 1912 (when values were still reasonable), but lost his fortune in the Crash of 1929. |
| "Common Stocks as Long Term Investments (1928)", Paperback, Edgar Lawrence Smith
A Wall Street classic influential in creating the Common Stock Legend |
| "Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor", Paperback, John C. Bogle
John Bogle, head of the Vanguard Group, became rich promoting the Common Stock Legend and mutual funds. |
| "Alchemy: Turning Common Stocks Into Gold: How Anyone, Anywhere Can Turn the Stock Market in the Ultimate Cash-Flow Machine", Paperback, Rod Czonlka
The Common Stock Legend in an extreme form. |
"The General Theory of Employment, Interest, and Money", Paperback, John Maynard Keynes
Keynes saw the stock market as a game between speculators competing for capital gains at the expense of others. |
| "The Coming Generational Storm: What You Need To Know About America's Economic Future", Hardcover, Laurence J. Kotlikoff, Scott Burns
Baby Boomers that blindly have invested according to the Common Stock Legend are likely to have a rude awakening upon retirement. |
| "Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies", Hardcover, Jeremy J. Siegel
The Common Stock Legend in its purest form. |
| Money. magazine, monthly
An good way to keep up with what the masses are thinking in a world of workers' capitalism. Ads of fund managers and brokers promote the Common Stock Legend. |
| "Wall Street to Main Street: Charles Merrill and Middle-Class Investors", Hardcover, Edwin J. Perkins
An example of high ethics on Wall Street, Charles Merrill actually told his clients to get out of stocks in 1929. |
| "Sins of the Father: Joseph P. Kennedy and the Dynasty He Founded", Hardcover, Ronald Kessler
Rum-runner, anti-Semite, Nazi sympathizer, and market manipulator, Joseph Kennedy was the first Chairman of the SEC. |
| "Wall Street", DVD, Charles Sheen, Michael Douglas (Actors); Oliver Stone (Director)
Hollywood black propaganda against Wall Street, where the good guy is on the side of the unions, and the bad guy (Gordon Gecko) stands for raw greed. |
| "The End of Shareholder Value: Corporations at the Crossroads", Paperback, Allen A. Kennedy
Some well-argued suggestions of how to get beyond the Common Stock Legend |
| "Blind Faith: Our Misplaced Trust in the Stock Market and Smarter, Safer Ways to Invest", Paperback, Edward Winslow
The Common Stock Legend debunked. |
| Prudent Man Rule : The modern version of the "prudent man rule" is the Uniform Prudent Investor Act, drafted by the National Conference of Commissioners on Uniform State Laws in 1995. [Return] |
| Great Depression : A history teacher's links about the 1920s and the 1930s. [Return] |
| Gold Standard : Authoritative article by Michael C. Bordo in "The Concise Encyclopedia of Economics". [Return] |
| Own a Share of America : Advertisement published in 1956 shows two police officers talking about investing in the NYSE. [Return] |
| 401(k) Plans : All about 401(k) plans from 401(k).org. [Return] |
| Total Returns : Definition by Professor Jeremy J. Siegel in "The Concise Encyclopedia of Economics". [Return] |
| S&P Averages : Historical data on the Standard and Poor's stocks. [Return] |
