Of Stocks & Returns

Yale economist Irving Fisher’s contribution to financial economics was particularly important. He took the mathematics of present value and applied it to investment decisions.

In Fisher’s analysis, corporate managers acting in the best interests of shareholders should choose projects with the highest positive net present value that takes into account not only the time value of money but also the risk of the project. Generations of Yale graduates who took his courses in finance learned to apply this rational decision criterion. Fisher’s net present value equation is the workhorse of all modern financial analysis today.

His study of corporations and analysis of the effects of inflation led him to strongly advocate stock investing as opposed to bond investing. It was advice he took himself. Edgar Lawrence Smith worked on Wall Street as a bond analyst in the early 1920s. Interested in the stock market craze, he ran a test to see whether an investor who held stocks would have done better than an investor who held bonds over the long term. Which did better — stocks or bonds?

Smith’s experiment was simple. He checked whether the actual cash flows from investing from the 1830s to the 1920s in corporate stocks would have covered the payouts to bondholders. He found that over the long term, stocks practically always beat bonds.

(From: “Money Changes Everything: How Finance Made Civilization Possible”)


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