It was considered common knowledge, prior to 1924, that stocks performed better than bonds during periods of inflation and bonds were better than stocks under deflation. As far as “truths” go, it’s not that outlandish. It almost makes sense.
Only, nobody bothered to test the assumption until Edgar Lawrence Smith came around. He tested it and came to a surprising conclusion for the time. Stocks, for the most part, do better than bonds during periods of inflation and deflation. He concluded it was because retained earnings, reinvested back into a business, increases the value of the company which eventually gets reflected in the stock price.
His book, Common Stocks As Long Term Investments, spread the news far and wide, becoming the new common knowledge. But it was shortlived.
Sometime between publishing the book and October 1929, some investors took Smith’s news to mean something else. “For the most part” was replaced by “always.” As in, stocks,
for the most part always, do better than bonds…
Investors and the market ate it up. And it ended horribly in the ’29 crash.
Two basic lessons come out of this episode. Testing “truths” can lead to facts that reframe how people think about something and the narrative around facts can be warped, creating problems. Continue Reading…