THAT WONDERFUL PARABLE ABOUT the Gotrocks family in Chapter 1 brings home the central reality of investing: “The most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn,” in the words of Warren Buffett. Illustrating the point with Berkshire Hathaway, the publicly owned corporation that he has run for 46 years, please heed carefully Mr. Buffett’s statement:

When the stock temporarily overperforms or underperforms the business, a limited number of shareholders— either sellers or buyers—receive outsized benefits at the expense of those they trade with. . . . Over time, the aggregate gains made by Berkshire shareholders must of necessity match the business gains of the company.

“Over time, the aggregate gains made by . . . shareholders must of necessity match the business gains of the company.”

How often investors lose sight of that eternal principle! Yet the record is clear. History, if only we would take the trouble to examine it, reveals the remarkable, if essential, linkage between the cumulative long-term returns earned by U.S. business—the annual dividend yield plus the annual rate of earnings growth—and the cumulative returns earned by the stock market. Think about that certainty for a moment. Can you see that it is simple common sense?

Need proof? Just look at the record since the beginning of the twentieth century (Exhibit 2.1). The average annual total return on stocks was 9.5 percent. The investment return alone was 9.0 percent—4.4 percent from dividend yield and 4.6 percent from earnings growth.

That difference of 0.5 percentage points per year arose from what I call speculative return. Speculative return may be a plus or a minus, depending on the willingness of investors to pay either higher or lower prices for each dollar of earnings at the end of a given period than at the beginning.

The price/earnings (P/E) ratio measures the number of dollars investors are willing to pay for each dollar of earnings. As investor confidence waxes and wanes, P/E multiples rise and fall.¹ When greed holds sway, very high P/Es are likely. When hope prevails, P/Es are moderate. When fear is in the saddle, P/Es are typically very low. Back and forth, over and over again, swings in the emotions of investors are reflected in speculative return. They momentarily derail the steady long-range upward trend in the economics of investing.

As reflected in Exhibit 2.1, the investment return on stocks—dividend yield plus earnings growth—tracks closely with the total market return (including the impact of speculative return) over the long term. Any significant divergences between the two are short-lived.

Compounding these returns over 116 years produces accumulations that are truly staggering. Each dollar initially invested in stocks in 1900 at a return of 9.5 percent grew by the close of 2015 to $43,650.² Sure, few (if any) of us have 116 years in us! But our descendants follow us, and, like the Gotrocks family, enjoy the miracle of compounding returns. These returns have been little short of amazing—the ultimate winner’s game.

As Exhibit 2.1 makes clear, there are bumps along the way in the investment returns earned by our business corporations. Sometimes, as in the Great Depression of the early 1930s, these bumps were large. But we got over them. So, if you stand back from the chart and squint your eyes, the trend of business fundamentals looks almost like a straight line sloping gently upward, and those periodic bumps are barely visible.

Reversion to the mean.

To be sure, stock market returns sometimes get well ahead of business fundamentals (as in the late 1920s, the early 1970s, and the late 1990s, perhaps even today). But it has been only a matter of time until, as if drawn by a magnet, they ultimately return to the long-term norm, although often only after falling well behind for a time, as in the mid-1940s, the late 1970s, and the 2003 market lows. It’s called reversion (or regression) to the mean (RTM), which we’ll discuss in depth in Chapter 11.

In our foolish focus on the short-term stock market distractions of the moment, we investors often overlook this long history. When the returns on stocks depart materially from the long-term norm, we ignore the reality that it is rarely because of the economics of investing—the earnings growth and dividend yields of our corporations. Rather, the reason that annual stock returns are so volatile is largely because of the emotions of investing, reflected in those changing P/E ratios.

“It is dangerous . . . to apply to the future inductive arguments based on past experience.”

What Exhibit 2.1 shows is that while the prices we pay for stocks often lose touch with the reality of corporate values, in the long run reality rules. So, while investors seem to intuitively accept that the past is inevitably prologue to the future, any past stock market returns that have included a high speculative stock return component are deeply flawed guides to what lies ahead. To understand why past returns do not foretell the future, we need only heed the words of the great British economist John Maynard Keynes. Here’s what he wrote 81 years ago:

It is dangerous . . . to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was.

But if we can distinguish the reasons the past was what it was, then we can establish reasonable expectations about the future. Keynes helped us make this distinction by pointing out that the state of long-term expectation for stocks is a combination of enterprise (“forecasting the prospective yield of assets over their whole life”) and speculation (“forecasting the psychology of the market”).

I’m well familiar with those words, for 66 years ago I incorporated them into my senior thesis at Princeton University. It was entitled, “The Economic Role of the Investment Company.” It led, providentially, to my lifetime career in the mutual fund industry.

The dual nature of stock market returns.

This dual nature of returns is clearly reflected when we look at stock market returns over the decades (Exhibit 2.2). Putting my own numbers to Keynes’s idea, I divide stock market returns into two parts: (1) investment return (enterprise), consisting of the initial dividend yield on stocks plus their subsequent earnings growth (together, they form the essence of what we call “intrinsic value”), and (2) speculative return, the impact of changing price/earnings multiples on stock prices. Let’s begin with investment returns.

The top section of Exhibit 2.2 shows the average annual investment return on stocks over each of the decades since 1900. Note first the steady contribution of dividend yields to total return during each decade: always positive, only twice outside the range of 3 percent to 7 percent, and averaging 4 percent.

Then note that the contribution of earnings growth to investment return, with the exception of the depression-ridden 1930s, was positive in every decade and above 9 percent in several decades, but usually ran between 4 percent and 7 percent, and averaged 4.6 percent per year.

Result: Total investment returns (the top section, combining dividend yield and earnings growth) were negative in only a single decade (again, in the 1930s). While these decade-long total investment returns—the gains made by business—varied, I consider them remarkably steady. They generally ran in the range of 8 percent to 13 percent annually, and averaged 9 percent.

Enter speculative return.

Enter speculative return, shown in the middle section of Exhibit 2.2. Compared with the relative consistency of dividends and earnings growth over the decades, truly wild variations in speculative return punctuate the chart. P/Es wax and wane, often with a remarkable impact on returns. For example, a 100 percent rise in the P/E, from 10 to 20 times over a decade, would equate to a 7.2 percent annual speculative return.

As you can see, without exception every decade of significantly negative speculative return was immediately followed by a decade in which it turned positive by a correlative amount: the negative 1910s and then the roaring 1920s; the dispiriting 1940s and then the booming 1950s; the discouraging 1970s and then the soaring 1980s.

This pattern is reversion to the mean writ large. RTM can be thought of as the tendency for those P/Es to return to their long-term norms over time. Periods of subpar performance tend to be followed by periods of recovery, and vice versa. Then, amazingly, during the 1990s, there was an unprecedented second consecutive exuberant increase, a pattern never before in evidence.

A return to sanity.

In April 1999, the P/E ratio had risen to an unprecedented level of 34 times, setting the stage for the return to sanity in valuations that soon followed. The tumble in stock market prices gave us our comeuppance. With earnings continuing to rise, the P/E currently stands at 23.7 times, compared with the 15 times level that prevailed at the start of the twentieth century. As a result, speculative return has added just 0.5 percentage points to the annual investment return earned by our businesses over the long term.³

Combining investment return and speculative return: total stock market returns.

When we combine these two sources of stock returns, we get the total return produced by the stock market. (The lower section of Exhibit 2.2.) Despite the huge impact of speculative return—up and down—during most of the individual decades, there is virtually no impact over the long term. The average annual total return on stocks of 9.5 percent, then, has been created almost entirely by enterprise, with only 0.5 percentage point created by speculation.

The message is clear: In the long run, stock returns depend almost entirely on the reality of the investment returns earned by our corporations. The perception of investors, reflected by the speculative returns, counts for little. It is economics that controls long-term equity returns; the impact of emotions, so dominant in the short term, dissolves.

Accurately forecasting short-term swings in investor emotions is not possible. But forecasting the long-term economics of investing has carried remarkably high odds of success.

Even after more than 66 years in this business, I have almost no idea how to forecast these short-term swings in investor emotions.⁴ But, largely because the arithmetic of investing is so basic, I have been able to forecast the long-term economics of investing with remarkably high odds of success.

Why? Simply because it is investment returns—the earnings and dividends generated by American businesses—that are almost entirely responsible for the returns delivered in our stock market over the long term. While illusion (the momentary prices we pay for stocks) often loses touch with reality (the intrinsic values of our corporations), it is reality that rules in the long run.

The real market and the expectations market.

To drive this point home, think of investing as consisting of two different games. Here’s how Roger Martin, dean of the Rotman School of Management of the University of Toronto, describes them. One game is “the real market, where giant publicly held companies compete. Where real companies spend real money to make and sell real products and services, and, if they play with skill, earn real profits and pay real dividends. This game also requires real strategy, determination, and expertise; real innovation and real foresight.” Loosely linked to this game is another game, the expectations market. Here, “prices are not set by real things like sales margins or profits. In the short term, stock prices go up only when the expectations of investors rise, not necessarily when sales, margins, or profits rise.”

The stock market is a giant distraction to the business of investing.

To this crucial distinction, I would add that the expectations market is largely a product of the expectations of speculators, trying to guess what other investors will expect and how they will act as each new bit of information finds its way into the marketplace. The expectations market is about speculation. The real market is about investing. The stock market, then, is a giant distraction to the business of investing.

Too often, the market causes investors to focus on transitory and volatile short-term expectations, rather than on what is really important—the gradual accumulation of the returns earned by corporate businesses.

When Shakespeare wrote that “it is a tale told by an idiot, full of sound and fury, signifying nothing,” he could have been describing the inexplicable daily, month-by-month, or even annual swings in stock prices. My advice to investors: ignore the short-term sound and fury of the emotions reflected in our financial markets, and focus on the productive long-term economics of our corporate businesses. The way to investment success is to get out of the expectations market of stock prices and cast your lot with the real market of business.