In the United States over the past 100 years, investments in stocks delivered an average 6% more than safe investments in short-term government securities. This differential has been quite stable over time, although between 1947 and 1994 it was slightly higher at 8%. The numbers are similar in other countries. In Italy between 1961 and 1994, for example, stock investments brought an average return of around 6% more than investments in treasury securities. Certainly, there have been extraordinary periods, such as the 1950s, when the differential between investing in the stock exchange in Milan and treasury securities climbed to over 22%. But there were also unlucky periods: in 1961-1970 the average differential was -2%.
Higher returns mean higher risks, as simple as that. If, instead of investing in the Standard & Poor’s 500, an investor puts his savings in small, and often more innovative, companies (the so- called “small caps”), his return would have gone up in the last 50 years by 6%, i.e., a mere 15% over that on ultra-safe government securities. But the risks that investor faced would also have doubled, for the volatility of returns on short-term government securities was 3% during the same 50 years, but a whopping 17% for the S&P index, and 30% for small cap stocks. Still, long-term investments in stocks do yield more than investments in government securities, but the heightened volatility means that decades must pass before we can safely conclude that an average stock investment has indeed brought higher returns.
The history of the so-called new economy stocks is too short to allow anyone to say whether their extraordinary performance in more or less all countries over the last few years is a temporary speculative boom or an irreversible result of the new economy. Annuals return in Italy, for example, between Christmas and the end of the first quarter of this year was 120%. But the greater volatility of the last few weeks saw the index of new European stocks lose at least 30% of its value.
The fear now is that a new generation of investors, including those who invest from their computers at home and have never tasted a bear market, is underestimating the risks. In the United States, where the boom has lasted longest, many observers have no doubt that the market is in a bubble. Looking at price earning ratios on Wall Street, Robert Shiller, an economist at Yale and one of the most convinced bulls, observed recently that stocks have never been more overvalued, not even in the summer of 1929, before the Great Crash.
The data, at least for the American economy, certainly shows that the new economy is generating extraordinary productivity increases. But in light of historical experience, this may not be all that convincing. At the previous turn of the century, the world saw the introduction of the electric engine and the telegraph, both clearly inventions of comparable significance to the Internet. Yet, during that period, the differential in returns between stocks and treasury securities was still around 6%.
In sum, the lesson of the new economy is not that one gets rich without effort, simply by speculating. The new economy teaches us that research, technological innovation, and entrepreneurial spirit in a competitive market have a high payoff. Europe has imported from the United States some of the negative aspects of the market, such as speculation. But it has not yet moved toward the more important features of the American economy, such as deregulation of labor and product markets, and a reduction in the weight of the public sector on the economy. Market falls in America might quickly be overcome because of the underlying strength of the American economy; Europe holds no such underlying strength in reserve. For individual investors, stocks remain personal risks; for Europe as a whole, bursting any speculative bubble could risk economic stability.
