**PREFACE:**This is the ninth in a series of posts highlighting the classic investing insights of William Bernstein from the 1990s and early 2000s. Many new Bogleheads have never been exposed to his early writings — and while the data sets used may seem antiquated, his portfolio concepts and novel analyses are still helpful to investors today, new and old alike.

Previous topics in the series: 1-Asset Allocation & Time Horizon, 2-Choosing Portfolio Bond Duration, 3-Diversifying Portfolio Equities, 4-Stocks Always Beat Bonds?, 5-What’s a Thing Worth?, 6-The Value Premium & Inflation, 7-The Great Fund Fee Mystery, 8-Is Credit Risk Ever Worth Taking?

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One of the biggest areas of confusion for novice investors is just where stock returns come from. The most popular misconception is that future stock returns somehow derive from past stock returns — that is, from the Stock Returns Fairy. The fallacy of this approach is obvious: If you pay twice as much for an asset than you should have, that increases the returns of the person who sold it to you, just as surely as it reduces your future return.

*So just where do stock returns actually come from?*

**Dividends & Market Multiple.**In this analysis, Mr. Bernstein first asks us: How much would you be willing to pay for a business that distributes $10,000 each and every year. Let’s say you arrive at a figure of $200,000. You’ve just determined that the annual return on your investment will be 5% ($10,000/$200,000). This is the same as saying you’re valuing the income stream of that business at 20 times its annual income. This is its

*market multiple*and what determines the value of your business on a day-to-day basis. If tomorrow the market decides your business is only worth 15 times its income (which is still $10,000 per year), you have lost 25% of your investment value. However, over the long term, the fundamental increases in stock prices come from one source only: increases in earnings/dividend income (chart below).

Note: Post-1930s, the increased growth rates are due to higher inflation.

Source: William Bernstein, Efficient Frontier (4/03)

**Earnings Growth.**Next, Mr. Bernstein asks us to assume that the earnings of our business are growing at the rate of 5% per year. If the market multiple remains at 20 times the income of the business, then so too will the market value of our business also increase by 5% per year. In other words, since next year our business will be earning $10,500, it will be worth 20 times that, or $210,000. If the market multiple remains the same, our return will be the sum of the income rate (5%) and the growth rate (5%), or 10% per year. Putting it all together, he offers this simple formula:

What final conclusions does Mr. Bernstein draw from this analysis?

- a) On any given day, the change in market price is caused almost entirely by the change in market multiple.

b) Over long holding periods though, the stock market’s dividend yield and earnings/dividend growth will determine its return. In other words, the market’s fundamental return overwhelms the fluctuations in its market multiple over time.

c) The long-term, expected return of the stock market is simply the sum of its dividend yield (say 2%), plus its earnings/dividend growth rate (say 4.5%), for a nominal return of 6.5% — assuming no change in market multiple.