By Christopher M. Wright

Name: Jeremy Siegel, Ph.D. Title: Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania Born: 1945 Experience: Professor Siegel (www.jeremysiegel.com) received his Ph.D. from MIT and taught at the University of Chicago before moving to the Wharton School. In addition to his book, "Stocks for the Long Run," he has contributed articles to The Wall Street Journal, Barron's, The New York Times and the Financial Times of London. Among his many awards are the Graham and Dodd Award for Best Article in the Financial Analysts Journal (1992) and Best Business School Professor from Business Week (1994). He is a frequent commentator on CNBC, CNN, NPR and Wall Street Week. He is an advisor to the Federal Reserve and serves on the Investment Advisory Committee of Zeneca Inc.

Well-known Wharton professor and market commentator Jeremy Siegel is the author of "Stocks for the Long Run," which has been called "one of the best investment books of all time." Real Estate Portfolio recently asked Professor Siegel about his long-term bullish outlook and the prospects he sees for REIT stocks.

Portfolio: Describe your reasons behind "Stocks for the Long Run"?
Siegel: Stocks consistently give the highest return of any asset class. The margin over bonds is substantial and will remain so in the future. The risk of stocks is lower than bonds over long time horizons of 20 years or longer. With bonds, you have to deal with inflation uncertainty when you hold that long. TIPS [Treasury Inflation-Protected Security government bonds] are the only thing safer than stocks, but the yields on these are low at the present time.

Portfolio: What kind of returns are we talking about in the long run?
Siegel: Stocks have returned an average of 6.5 percent to 7 percent per year after inflation over the last 200 years. I expect stocks to return only 5 percent to 6 percent after inflation over the next 25 years, and that's because valuations are high right now. High valuations lead to somewhat lower returns looking forward.

Portfolio: Still, that makes you a long-term bull. The classic mistake that bearish managers make is that they get out too soon and miss most of an ensuing bull market. What mistakes do bullish investors tend to make?
Siegel: They put more money into stocks that are rising, trying to hit it big. They chase exciting sectors like technology. This produces overpricing in those issues, subsequently leading to poor returns. I wrote an op-ed piece in the Wall Street Journal in March 2000 at the height of the tech bubble telling people to get out of tech completely.

Portfolio: You do not subscribe to the "random walk" theory that, as presented in your book, holds that future returns in the stock market are completely independent of past returns. Instead, you say that returns are remarkably consistent when viewed over long time horizons and that shorter term fluctuations always revert to the mean for reasons that are not well understood. Are you any closer to understanding the reasons for reversion to the mean now than when you wrote your book? What is magic about a 6.5 percent to 7 percent real return?
Siegel: I'm not any closer to understanding why 6.5 percent to 7 percent is the long-term average. It has to do with long-term average economic growth and the equity risk premium that investors require to invest in stocks. Regarding reversion to the mean, however, I'm thinking now that it stems from investor psychology. It seems to be related to psychologically induced swings of bullish and bearish sentiment that produce alternating periods of overvaluation and undervaluation.

Portfolio: Average market PE (price to earnings) ratios are still high, even after four years of working out the bubble. If stock returns revert to the mean, why not PEs?
Siegel: You ask a good question. I've thought about this quite a bit and researched it. I think that stocks have been undervalued through history and are only now approaching fair value. The average historical PE of 15 is way too low for today's market. Higher multiples of 20 to 22 are more appropriate because there have been fundamental and structural changes in the market, like greater liquidity, lower transaction costs and ease of diversification. Through most of the 20th century, it was difficult for individuals to have a diversified portfolio. Now it's easy with index mutual funds and ETFs (exchange-traded funds), especially with transaction costs being so low. Now investors can reduce their risk through diversification. As they move more to equity, this leads to higher share prices and valuations. There have also been favorable changes in the tax code lately. Dividend and capital gains taxes are near all-time lows and this is favorable for higher valuations.

Portfolio: OK, but the average PE on the S&P 500 is 29 as we speak here in early April.
Siegel: Trailing earnings coming out of a recession are very depressed by write-offs. Projected earnings are higher even if stock options are fully expensed. An S&P 500 at 1,130 is almost exactly 20 times 2004 option-adjusted earnings and that's what you have to look at.

Portfolio: Your book has been called the "buy-and-hold bible" yet it gives a "cautious nod" to market timing. How can this be?
Siegel: I do believe in some market timing. When I advised people to get out of the tech bubble, that was market timing. The problem is that a lot of market timers go deeper in the market when they should be lightening up. They end up in worse shape by trying to time the market than if they were simply to buy-and-hold a diversified portfolio. Others get out and adopt timing rules ensuring they never get back in. They end up underperforming by lacking exposure to the market.

Most investors should index 60 percent to 80 percent of their portfolio. For those who want to play on the side, it is possible to enhance returns using seasonality or some other timing method without being wildly speculative.

Portfolio: Is the buy-and-hold philosophy properly applied to individual issues? I mean, individual companies go belly-up all the time.
Siegel: I don't make very many recommendations about individual issues. Investing in individual stocks, as opposed to indexing, is a very difficult game where you must have complete control over your emotions. But I do own some individual stocks. I buy them when values are persuasive and sell them when they're fairly valued. I'm a dividend yield guy. I like individual issues with good, steady cash flow. It's protection in a bear market.

Portfolio: It's been reported that you hold REITs. Is the dividend the reason why?
Siegel: Yes, the dividends on REIT stocks are very important to me. When I got out at the top of the tech bubble, I asked myself what I should go into next. The Internet was supposed to put retail out of business and I thought, "no way." We heard that before about the telephone and the catalog. REITs were yielding 7 percent to 9 percent at the time and I said to myself, "I don't care if they don't go up, I'll just take the dividends."

Portfolio: Do you have a REIT fund or individual shares?
Siegel: Both. The fund has industrial, office and apartment REITs in it, and I looked for individual issues that were undervalued rather than in some particular segment of the market.

Portfolio: When would you sell your REITs?
Siegel: I'm holding them long term and reinvesting the dividends which buys more shares when the price goes down. Price declines are not unwelcome to the long-term investor. Reinvesting during price declines buys you more shares than if the stock remains high.

Portfolio: You wrote in 1994 that REITs had performed relatively well in the previous 30 years. How have you gauged their performance since then and what's ahead?
Siegel: REITs are coming into their own as an asset class. People are looking for yield and REITs have it. Looking ahead, we'll see more equitization of real estate. REITs were unfazed when the tax rate on qualified dividends was lowered in 2003. This is because people still wanted high yield, so demand for REIT shares stayed high as people put more of them in their 401(k) accounts where nonqualified dividends are sheltered.

As I mentioned earlier, we're headed into a lower yield world than in the last 50 years. Returns on stocks and bonds are already both down a couple of points. Anything like REITs that throws off cash will be a favored asset.

The real estate sector performs well most of the time, in periods of low inflation as well as high inflation. The only time I expect REITs to underperform is when the rest of the economy is booming and real estate can't compete with returns in sectors that catch fire.