Investors may have developed too rosy a view of equity returns
IF THERE is an article of faith among investors, it is that equities are the best investment over the long run, far better than government bonds. But research from Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School into returns since 1900, published this week in the "Credit Suisse Global Investment Returns Yearbook", suggests that this belief is misleading. Their data show, for example, that global bonds have delivered a better return than equities since the start of 1980. Thirty-three years is a long time by most people's reckoning.
Add to that the problem of survivorship bias. Most investment research has focused on America, where there are a lot of finance professors. America was the great winner of the 20th century, both militarily and economically. Although its success seems obvious now, it was not the only great power a century ago nor was it the most-favoured market of early-20th-century investors.
The chart shows that in the 50 years after the end of the American civil war, the Russian stockmarket easily outperformed Wall Street. Russia, with its vast territory and industrialising workforce, was seen as the exciting growth opportunity for the 20th century. (Argentina was another favourite bullish bet.) The St Petersburg market was suspended at the start of the first world war but reopened briefly in 1917, just in time for a vigorous rally.
You can imagine the investment-bank research notes of the day. "The appointment of Kerensky is positive for shares. The tsar's rule was erratic and a new technocratic government is in place. Now that the Russian market has reopened for business, St Petersburg is a buy." Within a couple of years, however, investors in Russian equities and in government bonds and bills had all been wiped out.
Austria has been another great historical disappointment. In the early years of the 20th century Austria-Hungary was still one of the great powers of the world, with an empire spanning much of south-eastern Europe. Defeat in two world wars, the break-up of the empire and two periods of hyperinflation meant that Austria had the worst real return of all 20 countries in the London Business School data, not just for equities but for government bonds and bills as well. An American investor who placed $1m in Austrian government bills in 1900 would now have just $100 left.
Austria shows that equities do not always pay off over the long term. Between 1900 and 2012 an investor in Austrian equities would have endured a period of 97 consecutive years of real losses. Investors in Italy and Belgium suffered real losses over periods lasting more than 70 years.
The inclusion of Russia and Austria in the database (plus China, where investors also suffered a 100% loss in 1949) is one reason why the professors show a lower historical global real annual return from equities (5% versus 5.4%) than they did in the 2012 edition of the yearbook.
The other reason is that the authors have moved to a weighting based on market capitalisation rather than on GDP when compiling the global index. That shift lowered the contribution of the successful American market. Indeed, American investors may not realise how lucky they were. The real return from American equities between 1900 and 2012 averaged 6.3% a year; the return from the rest of the world was just 4.4%.
Looking ahead the professors think that investors are unlikely to be as lucky again. Real equity returns may be 3-3.5% over the next 20-30 years, they reckon. Low real interest rates, which many people see as a bullish signal for the stockmarket, have historically been associated with low, not high, equity returns.
That is a problem because of the unrealistic assumptions many investors have made. Charities and endowments tend to spend 4% of their portfolios each year; if their real return is only 3%, they will steadily deplete their spending power.
The sponsors of American corporate-pension plans still expect 7.6% nominal returns from their portfolios, and fund their schemes accordingly. But given the plans' allocation of assets to low-yielding bonds, such targets imply a nominal return of 12.5% from equities, or 10% after inflation. That is way above the historical experience of stockmarket returns.
Congress has relieved the pressure on pension-plan funding by allowing companies to fiddle with the discount rate so as to make their liabilities look smaller. But as Mr Marsh remarks, this approach is akin to a homeowner who, upon hearing of the approach of a hurricane, decides not to board up his house but to smash his barometer.
