What Are Common Stocks?
Things have proceeded satisfactorily so far. Average rates of return on low-class bonds have been greater than rates on high-class bonds, and rates on common stocks have on the average generally exceeded rates on bonds. All of this is in accordance with what we would expect in a market dominated by risk-averse investors who expect to receive, and on the average actually receive, superior returns for holding asset of greater riskiness. When we turn to common stocks themselves, the results are less clear cut and satisfactory.
Unfortunately, there is no long-established commercial service which provides generally accepted ratings of the riskiness of common stocks. Investigators have usually provided their own rankings. Let us start with the work of Shannon Pratt.3 Pratt ranked all common stocks on the New York Stock Exchange according to the variability (standard deviation) of their monthly rates of return during two preceding periods of three and five years. For the three-year periods, Pratt ranked stocks for 372 different dates, beginning in January 31, 1929 and ending December 31, 1959. For the five-year periods, there were 348 periods, beginning in January 31, 1931. He then divided common stocks into quintiles on the basis of their historical variability in order to determine the average rate of return for each quintile during subsequent holding periods of one, three, five, and seven years.
His major finding can be easily summarized. If the first quintile includes the stocks with the least variable returns, the second quintile on the average generally has a higher rate of return than the first, the third generally has a higher return than the second, and the fourth generally has a slightly greater return than the third. The performance of the fifth quintile varies. In some instances, it has a lower rate of return than the fourth and a return not very different from the third. In other words, the relationship between risk as measured by historic variability and future returns is somewhat as we would expect, but not completely. Returns generally rise with risk as measured by historic variability, but at a decelerating rate. And, there is some suggestion that rates for the most variable quintile are less than for less variable quintiles.
These results require interpretation or explanation. The results are vaguely disturbing in that they represent a break in the smooth progression from very high-quality bonds with relatively low returns to low-quality bonds, to common stocks, and to common stocks of various degrees of riskiness. The fact that average rates of return on stocks of the lowest quality or with the greatest historic variability are lower than for stocks of higher quality or with smaller historic variability must be discussed.