Against the Gods: The Remarkable Story of Risk (36 page)

In 1986, Princeton economist William Baumol published an
enlightening study of long-run trends in productivity. His data came
from 72 countries and reached back to 1870.8 The study focused on
what Baumol calls the process of convergence. According to this
process, the countries with the lowest levels of productivity in 1870
have had the highest rates of improvement over the years, while the
most productive countries in 1870 have exhibited the slowest rates of
improvement-the peapods at work again, in other words. The differences in growth rates have slowly but surely narrowed the gap in productivity between the most backward and the most advanced nations as
each group has regressed toward the mean.

Over the 110 years covered by Baumol's analysis, the difference
between the most productive nation and the least productive nation
converged from a ratio of 8:1 to a ratio of only 2:1. Baumol points out,
". . . what is striking is the apparent implication that only one variable, a
country's 1870 GDP per work-hour, . . . matters to any substantial
degree."9 The factors that economists usually identify as contributing to
growth in productivity-free markets, a high propensity to save and
invest, and "sound" economic policies-seem to have been largely irrelevant. "Whatever its behavior," Baumol concludes, each nation was
"fated to land close to its predestined position."" Here is a worldwide
phenomenon that exactly replicates Galton's small-scale experiments.

Assessments of the performance of the United States change radically when appraised from this perspective. As the nation with the
highest GDP per work-hour among industrial countries since the turn
of the century, the relatively slow rate of growth in productivity in the
United States in recent years should come as no surprise. Each successive technological miracle counts for less as the base from which we
measure gets bigger. In fact, Baumol's data show that the U.S. growth
rate in productivity has been "just middling" for the better part of a
century, not merely for the past couple of decades. Between 1899 and
1913 it was already slower than the growth rates of Sweden, France,
Germany, Italy, and Japan.

Although Japan has had the highest long-run growth rate of all the
developed economies, except during the Second World War, Baumol
points out that it had the lowest level of output per worker in 1870 and
still ranks behind the United States. But the process of convergence
proceeds inexorably, as technology advances, as education spreads, and
as increasing size facilitates economies of scale.

Baumol suggests that dissatisfaction with the U.S. record since the
late 1960s is the result of myopia on the part of commentators who
overemphasize recent performance and ignore long-term trends. He
points out that the huge jump in U.S. levels of productivity from about
1950 to 1970 was not our preordained destiny, even for a nation as
technologically oriented as the United States. Seen in a longer perspective, that leap was only an aberration that roughly offset the sharp decline from historical growth rates suffered during the 1930s and the
Second World War.

Even though the subject matter is entirely different, Baumol's main
conclusions echo DeBondt and Thaler:

We cannot understand current phenomena ... without systematic
examination of earlier events which affect the present and will continue to exercise profound effects tomorrow.... [T]he long run is
important because it is not sensible for economists and policymakers
to attempt to discern long-run trends and their outcomes from the
flow of short-run developments, which may be dominated by transient conditions.11

Sometimes the long run sets in too late to bail us out, even when
regression to the mean is at work. In a famous passage, the great English
economist John Maynard Keynes once remarked:

In the long run, we are all dead. Economists set themselves too easy,
too useless a task if in the tempestuous seasons they can only tell us
that when the storm is long past the ocean will be flat.12

But we are obliged to live in the short run. The business at hand is
to stay afloat and we dare not wait for the day the ocean will be flat.
Even then its flatness may be only an interlude of unknown duration
between tempests.

Dependence on reversion to the mean for forecasting the future
tends to be perilous when the mean itself is in flux. The ReichensteinDorsettt projections assume that the future will look like the past, but
there is no natural law that says it always will. If global warming indeed
lies ahead, a long string of hot years will not necessarily be followed by
a long string of cold years. If a person becomes psychotic instead of
just neurotic, depression may be permanent rather than intermittent. If
humans succeed in destroying the environment, floods may fail to follow droughts.

If nature sometimes fails to regress to the mean, human activities,
unlike sweet peas, will surely experience discontinuities, and no riskmanagement system will work very well. Galton recognized that possibility and warned, "An Average is but a solitary fact, whereas if a
single other fact be added to it, an entire Normal Scheme, which nearly
corresponds to the observed one, starts potentially into existence."13

Early in this book we commented on the stability of the daily lives
of most people century after century. Since the onset of the industrial
revolution about two hundred years ago, so many "single other facts"
have been added to the "Average" that defining the "Normal Scheme"
has become increasingly difficult. When discontinuities threaten, it is
perilous to base decisions on established trends that have always seemed
to make perfect sense but suddenly do not.

Here are two examples of how people can be duped by overreliance on regression to the mean.

In 1930, when President Hoover declared that "Prosperity is just
around the corner," he was not trying to fool the public with a sound
bite or a spin. He meant what he said. After all, history had always supported that view. Depressions had come, but they had always gone.*
Except for the period of the First World War, business activity had fallen in only seven years from 1869 until 1929. The single two-year setback during those years was 1907-1908, from a very high point; the average annual decline in real GDP was a modest 1.6%, and that included one decline of 5.5%.

But production fell in 1930 by 9.3% and in 1931 by 8.6%. At the very bottom, in June 1932, GDP was 55% below its 1929 peak, even lower than it had been at the low point of the short-lived depression of 1920. Sixty years of history had suddenly become irrelevant. The trouble stemmed in part from the loss of youthful dynamism over the long period of industrial development; even during the boom of the 1920s, economic growth was below the long-term trend defined by the years from 1870 to 1918. The weakening of forward momentum, combined with a sequence of policy errors here and abroad and the shock of the stock market crash in October 1929, drove prosperity away from the corner it was presumably around.

The second example: In 1959, exactly thirty years after the Great Crash, an event took place that made absolutely no sense in the light of history. Up to the late 1950s, investors had received a higher income from owning stocks than from owning bonds. Every time the yields got close, the dividend yield on common stocks moved back up over the bond yield. Stock prices fell, so that a dollar invested in stocks brought more income than it had brought previously.

That seemed as it should be. After all, stocks are riskier than bonds. Bonds are contracts that specify precisely when the borrower must repay the principal of the debt and provide the schedule of interest payments. If borrowers default on a bond contract, they end up in bankruptcy, their credit ruined, and their assets under the control of creditors.

With stocks, however, the shareholders' claim on the company's assets has no substance until after the company's creditors have been satisfied. Stocks are perpetuities: they have no terminal date on which the assets of the company must be distributed to the owners. Moreover,
stock dividends are paid at the pleasure of the board of directors; the
company has no obligation ever to pay dividends to the stockholders.
Total dividends paid by publicly held companies were cut on nineteen
occasions between 1871 and 1929; they were slashed by more than 50%
from 1929 to 1933 and by about 40% in 1938.

So it is no wonder that investors bought stocks only when they
yielded a higher income than bonds. And no wonder that stock prices
fell every time the income from stocks came close to the income from
bonds.

Until 1959, that is. At that point, stock prices were soaring and
bond prices were falling. This meant that the ratio of bond interest to
bond prices was shooting up and the ratio of stock dividends to stock
prices was declining. The old relationship between bonds and stocks
vanished, opening up a gap so huge that ultimately bonds were yielding more than stocks by an even greater margin than when stocks had
yielded more than bonds.

The cause of this reversal could not have been trivial. Inflation was
the main factor that distinguished the present from the past. From
1800 to 1940, the cost of living had risen an average of only 0.2% a
year and had actually declined on 69 occasions. In 1940 the cost-ofliving index was only 28% higher than it had been 140 years earlier.
Under such conditions, owning assets valued at a fixed number of dollars was a delight; owning assets with no fixed dollar value was highly
risky.

The Second World War and its aftermath changed all that. From
1941 to 1959, inflation averaged 4.0% a year, with the cost-of-living
index rising every year but one. The relentlessly rising price level transformed bonds from a financial instrument that had appeared inviolate
into an extremely risky investment. By 1959, the price of the 2 1/2%
bonds the Treasury had issued in 1945 had fallen from $1,000 to
$820-and that $820 bought only half as much as in 1949!

Meanwhile, stock dividends took off on a rapid climb, tripling between 1945 and 1959, with only one year of decline-and even that a
mere 2%. No longer did investors perceive stocks as a risky asset whose
price and income moved unpredictably. The price paid for today's dividend appeared increasingly irrelevant. What mattered was the rising stream of dividends that the future would bring. Over time, those dividends could be expected to exceed the interest payments from bonds,
with a commensurate rise in the capital value of the stocks. The smart
move was to buy stocks at a premium because of the opportunities for
growth and inflation hedging they provided, and to pass up bonds with
their fixed-dollar yield.

Although the contours of this new world were visible well before
1959, the old relationships in the capital markets tended to persist as
long as people with memories of the old days continued to be the main
investors. For example, my partners, veterans of the Great Crash, kept
assuring me that the seeming trend was nothing but an aberration. They
promised me that matters would revert to normal in just a few months,
that stock prices would fall and bond prices would rally.

I am still waiting. The fact that something so unthinkable could
occur has had a lasting impact on my view of life and on investing in
particular. It continues to color my attitude toward the future and has
left me skeptical about the wisdom of extrapolating from the past.

How much reliance, then, can we place on regression to the mean
in judging what the future will bring? What are we to make of a concept that has great power under some conditions but leads to disaster
under others?

Keynes admitted that "as living and moving beings, we are forced
to act ... [even when]our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation."14 With rules of
thumb, experience, instinct, and conventions-in other words, gutwe manage to stumble from the present into the future. The expression "conventional wisdom," first used by John Kenneth Galbraith,
often carries a pejorative sense, as though what most of us believe is
inevitably wrong. But without conventional wisdom, we could make
no long-run decisions and would have trouble finding our way from
day to day.