The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between

CHAPTER 1

A Brief History of Financial Time

Many of life’s deepest questions, I have found, get asked over lunch.

This particular midday meal occurred in 2000 at a Chinese restaurant in Manhattan, and my companion was a well- known hedge- fund manager and contributor to the academic finance literature. We puzzled, as did many in finance at the time, over the historically high prices of stocks.

“What I cannot figure out,” my friend began, “is whether investors are really smart or really stupid.” Seeing my puzzled expression, he continued, “Maybe the equity risk premium is still high, in which case prices will mean revert, which means that stock investors are really stupid. Alternatively, the equity risk premium has gotten a lot lower in the past 10 years, in which case prices will not mean revert, which means stock investors are really smart.” Just what did he mean, and why was his question so important?

Since my friend is really smart and has worked in finance all his adult life, I have to translate his question into plain English: “In the past, stocks have had high returns because they have been really risky. But stocks are now so expensive that there are only two possibilities: either they are going to fall dramatically in price and then have higher returns after that (in which case investors are stupid for paying such high prices now), or there will be no big fall in price and little risk, but returns will hereafter be permanently low (in which case investors are smart). So ...