The Dow Jones industrial average is hovering near 30,000, some 20% away from a number that may resonate with readers who recall the dot.com era book, "Dow 36,000" by James Glassman and Kevin Hassett. Published in 1999 and penned when the Dow was around 9,000, they argued stocks were vastly undervalued and could rise to 36,000 in three to five years.
Oops. The long boom in stocks came to an end in March the following year. Dow 36,000 became a symbol of speculative exuberance. Yet the basic concept behind their forecast is worth revisiting with realistic prospects that the Dow could reach 30,000. Their core idea was wrong then and remains so today.
The fundamental notion informing modern finance theory is that the possibility of earning higher returns only comes as compensation for taking on greater financial risk. Investing in riskier assets means you might do better with your money while, at the same time, increasing the prospect of losing money. Stocks are considered riskier than bonds since equities represent the uncertain rewards for entrepreneurship. Bonds are long-term contracts that spell out when borrowers must make principal and interest payments.
The idea is while stocks may be more volatile than fixed income securities over the short haul, history suggests that stocks are far less risky than previously thought over long periods of time. That insight reached its apogee with their argument that stock and bond markets' expected returns were about equal. A similar risk profile meant the Dow should be trading at 36,000.
Financiers subsequently dissected their main errors. The notion that stock market risk falls over the long haul — 30, 50, 75 years and so on — ignores the reality that such long-term guidance isn't much help for individuals who need their money in shorter time spans. The risk is that returns will be terrible at the wrong time for your circumstances.
The real lesson for savers investing for their retirement (and similar goals) from the Dow 36,000 experience remains the same: Diversification pays. "There is no certainty. Rational people do not bet the ranch on a model that works out only for the most part. And God forbid it works out only for the minor part!" said Peter Bernstein, the late financial philosopher of risk in a 1999 interview. "Consequences, not probabilities, determine the decisions that matter. Diversification is still the optimal strategy for the long run."
Chris Farrell is senior economics contributor, "Marketplace," and Minnesota Public Radio.
