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      Jeremy Siegel of Wharton has performed a similar analysis in the United States over two centuries and finds a real return on stocks of about 7 percent a year. Historically speaking, the United States has been at the higher end of returns relative to other markets, with only Australia and South Africa doing better within the Elroy, Dimson, and Marsh data set.

      What is important about this data is not the absolute return that stocks deliver, though it is impressive, but that stocks consistently deliver higher returns than other asset classes on a medium- or long-term view. That’s what is relevant to the portfolio construction decision. Most strikingly, looking back from 1900 to 2014 in all of the countries where there is a full run of data, stocks outperform both bonds and bills. Clearly, there are periods of underperformance of stocks relative to bonds, often for a decade or more in some countries, but in the long-term view, stocks come out ahead.

      The Logic

      In addition to just looking at the historical numbers we can also consider logically why this is the case.

      First, when an economy is growing, stocks are levered to that growth, and they receive the profit that is left after fixed costs are paid. So as an economy grows, returns to equity can grow disproportionately. This is not true of fixed-income investments, where returns over the bond’s lifetime are capped by the coupon payment of the bond but could be less. While bonds offer a steady return, but with downside risk and no major upside, equities have more of a symmetrical risk profile in terms of potential upside and downside outcomes relative to bonds, which over the long term improves potential returns considerably. In addition, consider that although a stock can fall to zero – a loss of 100 percent – gains are not capped at 100 percent, since a stock can double or triple. The other benefit of stocks comes from pricing power.

      When inflation increases, the real returns to fixed income decrease. You receive a 3 percent coupon whether inflation turns out to be 1 percent or 5 percent. However, for stocks, if inflation rises to 5 percent, companies have an opportunity to raise prices 5 percent. Clearly not all will and not all can due to the actions of customers, regulators, or competitors, but generally stocks have some defense against rising inflation, whereas bonds are more exposed to it. However, inflation is hardly plain sailing for stock investors, as we’ll discuss in the next chapter.