The notion goes back to 1922, when a bond brokerage in New York City hired Edgar Lawrence Smith to put together a pamphlet explaining why bonds–and certainly not stocks–were the best long-term investment. At the time, this was conventional wisdom on Wall Street. Bonds were for investment, stocks for speculation–and, in those pre-SEC days, for manipulation. But when he investigated the historical record, Smith recounted later, “supporting evidence for this thesis could not be found.” Instead, he discovered that over every 20-year span he examined but one, stocks handily beat bonds.
In 1924, Smith published the results as a book called Common Stocks as Long Term Investments. It was a sensation. Smith–a businessman of no great distinction up to that point–launched a mutual-fund company on the strength of his sudden fame and got an invite from John Maynard Keynes to join the Royal Economic Society. His argument was that stocks would continue to beat bonds because they a) were less vulnerable to having their value eaten away by inflation and b) allowed investors to share in the growth of the U.S. economy in a way that bonds and other assets did not. These two tenets were the indispensable theoretical underpinning of the 1920s bull market.
After that boom came to a crashing end in 1929 and the market continued to implode in 1930, ’31 and ’32, this theoretical underpinning at first seemed to have been demolished. The idea that stocks could be good investments became a joke and remained that–in the popular view, at least–for decades. Yet whenever anyone in later years re-examined the data on stocks’ long-run performance–major scholarly studies on the topic were published in 1938, ’53, ’64 and ’76–they reached the same conclusion Smith did. Even with the dire experience of the early 1930s factored in, stocks had proved an excellent long-run investment, with returns that far outpaced those of bonds.
Finance scholars also bolted a third plank onto Smith’s two reasons this was so and would continue to be: stocks were riskier than bonds, and stock investors were thus being paid a premium for taking on that additional risk. Read the whole story here.