In response to my article on the financial mess, Goldblog reader Dan Simon writes in to explain the market's recent follies. In essence, investors have lost discipline:
Why have stocks consistently outperformed bonds over the long term?
The answer is simple: stocks have long outperformed bonds because stock market investors have consistently demanded superior returns from stocks, to the point of being willing to unload stocks that they judged incapable of generating those returns. That discipline has had the effect of keeping stock prices down, and hence return rates up: a stock too expensive to generate the requisite return on its investment gets bid down to the point where its return, given its price, is superior to that available on the bond market.
Then, around the early 1980s, the idea of index investing gained popularity. The original idea was quite clever: savvy, disciplined investors provided a reasonably good estimate of long-term stock returns, and ordinary investors could exploit that estimate by simply investing in the market as a whole, and sharing in the resulting high return rates. And as long as such passive investors were a small enough fraction of the investor population, the strategy worked perfectly.
But like all successful investment strategies, it fell victim to its own success and resultant popularity. As millions of investors poured their money robotically into the market, they bid up the price of stocks to the point where they couldn't possibly generate returns at their traditional rates. By that time, however, the strategy of carefully following the lead of disciplined investors had morphed into a kind of blind faith in the power of the market to generate high long-term return rates. So the zombie-like buy-and-hold investors kept coming, bidding stock prices higher and higher, and thus pushing return rates lower and lower.