ABSTRACT
In Chapter 1 we examined the big picture of the performance of US stocks over the long run. We concentrated on the 1990s bull run in Chapter 2. In this chapter, we examine ‘how’ and ‘why’ investors choose to invest in stocks over other types of assets-in essence, a critique of portfolio choice. As we noted in the previous chapter, safely storing wealth over a long time frame poses a whole array of hazards to the investor-inflation, tax regimes, interest rate changes and of course the ebb and sway of the business cycle. The desire for persistent higher rates of return involves higher than normal levels of risk-unavoidable risk. This chapter distinguishes between systematic risk (due to the business cycle) and unsystematic risk (due to insufficient diversification within the basket). It is the former type that wreaks havoc with valuations and rate of return performance. In the boom era perhaps some US investors believed that business cycles were no longer a threat or even had been repealed? Perceptions of systematic risk had definitely tilted towards unbounded optimism. At face value, traditional valuation techniques were thrown out the window. Warnings signals of overvaluation were ignored. This chapter outlines some fairly standard methods of valuing stocks and seeks to explain why there was a wayward departure from economic fundamentals and even the prime fundamental driving stock valuesthe expected rate of return or expected earnings per share.
