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cipally an issue between stocks on the one hand and bonds on the other-between equity or ownership types of securities and contractual types of securities. Geographic diversification and diversification by industry is commonly practiced by corporate fiduciaries as well as individuals in the investment of funds. It is in the third type of diversification that differences in practice are found. It is clear that diversification is desirable with respect to the first two types, but why is it necessary to diversify as between stocks and bonds? This question has been elaborately discussed in the last few years following the publication of Common Stocks as Long Term Investments. But before that time, scattered articles on the general subject had appeared, and the issue had been faced and sound theoretical conclusions drawn by several economists as well as others who had carefully studied the problem.2 Simply stated, the conclusion is that in periods of a rising general price level investments should be shifted to stocks while in periods of a falling general price level investments should be shifted to bonds. This is because in a period of generally rising prices, the stocks or equity type of securities will rise also, due to the increase in the dollar amount of returns or profits of enterprise; while in such periods bonds or the contractual type of securities do not increase in value, but if the general capitalization rate rises (which is likely to be the case) the market price of bonds will decline. On the other hand, in a period of generally falling prices, the stocks or equity type of securities will tend to decline in value also, due to the decrease in the dollar amount of returns or profits of enterprise; while in such periods bonds or the contractual type of securities do not decline in value, but if the general capitali

1 Published in 1924 by Edgar Lawrence Smith, New York City. Cf. for other references Bibliography, infra, pp. 533-7.

2 Irving Fisher, E. W. Kemmerer, H. G. Brown, W. E. Clark, J. P. Norton, Montgomery Rollins, and G. L. Summer, How to Invest when Prices are Rising-A Scientific Method of Providing for the Increasing Cost of Living (1912), especially Chap. IV, "Bonds as an Investment when Prices are Rising," by W. E. Clark, and Chap. V, "Stocks as an Investment when Prices are Rising," by J. P. Norton. Also Cf. Kemmerer, E. W., “Business and the Depreciated Dollar," Administration, Vol. 1 (Jan., 1921), pp. 19-29.

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zation rate falls (which is likely to be the case) 1 the market price of bonds will rise. This principle may be represented symbolically as follows:

Present worth of stocks or equity securities,—2

where x1 represents the expected income upon the security for the first year, x2 represents the expected income for the second year, x3 represents the expected income for the third year, and so on to an indeterminate series of future expected variable incomes, since stocks have no maturity date and do not yield a contractual or fixed dollar income. The annual returns will vary with the successes or failures of the enterprise, and they will also vary with long-time changes in the general price level. The capitalization rate, r, will likewise vary from period to period, and these variations will cause fluctuations in the present worth or market price of the security. Thus by way of summary,

Factors causing a rise in present worth of stocks,—

1. Increase in expected income due to success or growth of the enterprise.

2. Increase in expected income due to rise in general price level. 3. Decrease in the capitalization rate.

Factors causing a fall in present worth of stocks,

1. Decrease in expected income due to failure or decline in importance of enterprise.

2. Decrease in expected income due to fall in general price level. 3.-Increase in the capitalization rate.

Present worth of bonds or contractual securities,—

where "a" represents the annual contractual income on the bond, which is the same every year until maturity, when the principal, P, is also received. The number of years is determi

1 Cf. Fetter, F. A., Economic Principles, pp. 235-313, and by the same author Modern Economic Problems, pp. 86-8.

2 Ibid., Chap. 23, pp. 274-84, and Chap. 25, pp. 310-13.

nate and is represented by n. In other words, the only variable in this series is the capitalization rate, r. By way of summary.

Factor causing a rise in present worth of bonds,

1. Decrease in the capitalization rate.

Factor causing a fall in present worth of bonds,— 1.-Increase in the capitalization rate.

Thus, viewed from the point of view of market price or dollar's present worth, the problem of investment in the contractual type of security is a very simple one, while the investment in stocks or equity securities is complicated and subject to a larger number of contingencies. Now if it were true that the price level were perfectly stable, the bond investment would be as safe and conservative as it is usually assumed to be; but the price level is far from stable, as is well known. So far as actual amount of dollars received the bond presents a stable investment, but people cannot eat dollars, nor use them for clothing and shelter—it is the purchasing power of the dollar's worth of income which is of vital concern to the beneficiary of a trust and should be of concern to the trustee for that reason.

Irving Fisher likes to tell the following story:

"A friend of mine, a woman, was left in 1892, close to this period I refer to, a fortune of $50,000, put in trust, and the interest was paid to her, about $2,500 or $3,000 a year. In 1920 I went with her to see the trustee who had been managing her property all these years. The trustee showed us how carefully he had invested-only in 'safe' bonds, not in unsafe stock. He said he was sorry that in one case the bonds had deteriorated so that the principal was no longer $50,000, but $48,000. I said, 'I claim there has been an impairment of seventy per cent, or more.' He said, 'Nothing of the sort. You can look at my books.' I said, 'I haven't any doubt of your personal honesty." Then I explained to him what I have explained here. I said, "This lady has not been receiving any income. Her father put in your custody $50,000, which represented at that time a certain purchasing power, so much bread and butter and clothes and house-rent. If you had kept custody of that sum as real value in terms of human living, not merely as dollars, you would have the equivalent of it today, and the equivalent of it today

would be over $150,000. You haven't it. You have only $48,000. If you had really conserved that fortune in actual purchasing power, you would not have paid her that $2,500 every year. You would have re-invested out of that a sinking fund against the sinking value of the principal, so as to keep up the value of the principal to where it was when it was put in your hands. But you would have had to invest all of that $2,500! Therefore I claim she has not been receiving any income from a real unimpaired capital. The alleged income was all falsely kept on your books-not through your fault-but because you have been keeping it by false weight and measurejust as falsely as if in Germany a fortune of 50,000 marks in 1920 had been called as large as 50,000 marks in 1892.'

"He said, 'It is not my fault.' I said, 'No. But for heaven's sake, you people who are keeping fortunes of widows, orphans, colleges, hospitals, and churches, can't you be interested in something more than whether it is your fault or not? Can't you be interested in the great social effort of preventing these widows and orphans and hospitals and colleges from being robbed? This woman's income is only one-third in value of what it was when she began. If you had invested in ordinary stocks, she would have been richer rather than poorer, because the stockholders of this country have been winning what she as a bondholder has been losing."

Actual Speculative Nature of Stocks and Bonds Viewed in Terms of Livelihood. Granting that the variations in the purchasing power of the dollar constitute an important consideration, the present worth of stocks and bonds in terms of purchasing power may be presented in the following symbolical form:

1 "Ethics in The Monetary System," reprinted from Christian Work. He also related this story in hearings on the Strong Bill for stabilizing the

currency.

Where X1, X2, X3,... ...X.; represent the series of expected variable dollar incomes from the stock, and y1, y2, Yз..... . y∞ represent the variable purchasing power of money synchronous with the variable income.

Thus, the annuities are still variable, but less variable than before, because part of the former variability is due to fluctuations in purchasing power of the dollar and now that part is canceled out by dividing the dollar incomes by purchasing

real incomes, i. e., as measured in terms of livelihood.

So that the annual incomes from bonds are constant as expressed in dollars, but as expressed in terms of livelihood they are variable-in other words the contractual real income is unstable.

When expressed in terms of livelihood, so far as the speculative element or uncertainty as to future real incomes is concerned the only difference between stocks and bonds is that in one case the series of annuities is indeterminate and in the other case it is terminated by the repayment of the dollar principal at the end of a specified period. Thus the annuity as well as the final principal payment in the case of the bond or contractual type becomes a variable, quite as much, if not more, than the annuity in the case of the stock. Considered in terms. of purchasing power, much of the instability of stocks is concealed stability whereas much of the stability of bonds is concealed instability. This similarity of speculative character may be summarized as follows: