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A New Gloss on Stocks for the Long Run
on August 27, 2008
In the previous editions of Stocks for the Long Run, Wharton Finance professor Jeremy Siegel offered a thoroughly bullish take on the merits of equity investing that has proved highly influential and largely correct through the end of the post-Millennial Bull Market in mid-2007. In the latest edition of this classic, released in a much more difficult period of substantial market declines, Siegel has added important and more nuanced insights derived from his previous and somewhat overlooked book "The Future for Investors," which came out in 2006. Siegel's basic advice to stock investors is to focus less on growth stocks and index mutual funds (eg., Vanguard 500) and more on looking for tried and true stocks that pay high dividends. He argues that such reinvested dividends are the true source of stock returns, or the "El Dorado." (His term). Overall, this argument is well-presented and persuasive.
However, I am perplexed on a key element. His case is largely based on historical evidence that purports to show that high dividend yield stocks, with dividends reinvested, have accumulated more total return than growth stocks or index mutual funds. However, his calculations do not account for the deleterious effect of taxes on reinvested dividend. (He says in an endnote that taxes are not significant for the portfolios he chose, but does not explain why; for most common stock portfolios, taxes are significant.) Dividends are taxed yearly and until recently at a higher rate than that of capital gains and that of retained earnings, which are not taxed at all. If taxes have been paid on dividends, only the untaxed part can truly be considered "reinvested"; the part that is taxed has to be made up by a new infusions of cash from the investor. The effect of ignoring this is that his historical comparisons are not terribly meaningful because he is not calculating the returns on true (after tax) contributions to dividend stocks vs. growth stocks. Naturally, if more is contributed to the dividend stocks, there is likely to be more at the end. (BTW, this is basically the same fallacy that sunk the allegedly huge returns of the otherwise delightful "Beardstown Ladies" of yore.) Given that the magnitude of the "advantage" he posits of dividend stocks vs. growth stocks is not all that great, one cannot have confidence that he has truly made his case.
That said, his advice is very useful for investors in tax sheltered 401Ks. Also, the new lower tax rate on dividends also helps lessen, though not eliminate, the effects of yearly taxation of dividends.
In addition to emphasizing the importance of the contribution of stock dividends to equity portfolio performance, this book also grapples with a perplexing challenge to Siegel's original stocks for the long run mantra, the much vexed question of what will happen if and when the populous Baby Boom generation attempts to cash in its stock and bond retirement portfolios by selling them to the smaller demographic of Gen X and Gen Y. An entire school of catastrophe futurologists, most notably Harry Dent, but also more mainstream voices like Peter G. Peterson (The Grey Wave) have warned that this so-called Age Wave is about to wreak havoc with stock market investments. In this book, Siegel does not dismiss this issue, but deals with it in a logical and generally less alarmist point of view. At the risk of oversimplifying a complex analysis, Siegel's bottom line is that while it is true that there are not enough younger generation Americans to absorb the Boomers stock and bond assets at current prices, investors in emerging countries, like China and India, will more than make up for that and will end up buying the Baby Boomer's paper assets as the Boomers sell them off to fund their retirements. The upshot is that foreigners will end up owning a lot of our companies by the year 2050. A potential snag, says Siegel, is whether America will be willing to let this happen, or will pass laws or adopt polices to discourage the transfer of US assets to foreign countries. This remains to be seen, but he is optimistic. On the other hand, the implications for the typical Baby Boomer's most important asset, his or her house, is rather dire, because homes can't be sold as readily to foreigners, for obvious reasons. Siegel doesn't provide an answer for the housing market, which is outside the scope of a book on stock investing in any event. Overall, this remains one of the best written and most sensible investment books available today, now offering a more nuanced and even more helpful sets of advice than the previous editions. With new information and analysis, this is well worth owning, even if you have a previous edition.