Century of market history has harsh lessons for investors
Analysis shows investors underestimate volatility, overestimate the impact of economic growth and are poor at timing transactions
Traders on the floor of the New York Stock Exchange have an edge; but it’s very difficult for individual investors to make predictions on GDP that are not already embedded into stock prices. Photograph: Reuters
History matters. There’s little point trying to make investment decisions for the future if you don’t know what has worked in the past. In recent weeks, two exhaustive publications – the 2014 Global Investment Returns Yearbook and Barclays’ Equity Gilt Study – have examined market returns over the past century yielding many valuable, but often confounding, insights.
The yearbook is an annual update of the 2002 book Triumph of the Optimists , which popularised the “perverse” fact that economic growth is, peculiarly, negatively related to stock returns.
The latest yearbook returns to the growth puzzle, examining returns from 85 countries between 1972 and 2013. Result? Buying stocks in low-growth countries easily beat returns on offer in high-growth economies.
Past yearbooks have also found investors who bought equities in countries with weak currencies over the previous five years would have trounced those who bought into countries with strong currencies.
The most likely explanation is that strong GDP growth is already reflected in prices, investors bidding up asset prices and setting themselves up for sub-par long-term returns.
It’s not the case that future GDP growth is irrelevant to investors – if you were perfectly clairvoyant you would be in the money. The thing is, it’s very difficult to make predictions that are not already embedded in prices.
“Stock market fluctuations predict changes in GDP,” the yearbook concludes, “but movements in GDP do not predict stock market returns.”
Dividends have accounted for 42 per cent of US market returns since the 1930s, accounting for at least 33 per cent of returns in every decade except the 1990s. Dividends are particularly important in stagnant markets, accounting for 233 per cent of returns in the 1930s and 135 per cent from 2001-2010.
High-yielding shares tend to outperform, the 2011 yearbook notes – between 1900 and 2011, every £1 invested in high-yielding UK shares would have grown to £100,160 – almost 20 times the £5,122 returned from low-yielding shares. This yield effect was found in 20 out of 21 countries studied, the average yield premium a “striking” 4.4 per cent per year.
Investors who spend their dividends are losing out. The latest Barclays Equity Gilt Study notes that £100 invested in UK equities in 1900 would, with dividends reinvested, be worth £28,386 in real terms today.
If you didn’t reinvest, however, your inflation-adjusted portfolio would be worth just £191.
Volatility is the norm
Investors might be less prone to being spooked by market falls if they remembered that volatility is the norm not the exception.
Although the US market has returned an average of more than 9 per cent over the last 85 years, there have been only 14 years where the annual return was within the 0-10 per cent range during that period – just one year in six. Returns can be lumpy: great one year, awful the next. Since 1871, markets have either risen or fallen by more than 20 per cent in more than 40 per cent of all years. Since 1945 there have been 27 double-digit corrections and 12 bear markets (losses of at least 20 per cent).
Earlier this month headlines screamed that some $3 trillion (€2.18 trillion) had been wiped off global equities in a matter of weeks – a fall of 5.5 per cent. The S&P 500 has seen 19 pullbacks of more than 5 per cent since March 2009, since when the index has gained 170 per cent.
“Remember, this the next time someone tries to explain why the market is up or down by a few percentage points,” said Fool.com finance writer Morgan Housel. “They are basically trying to explain why summer came after spring.”
Stock-picking is difficult
US indices rose tenfold between 1983 and 2006. Yet a Longboard Asset Management report that looked at the country’s 3,000 biggest stocks found that 39 per cent were unprofitable, 18.5 per cent lost at least three-quarters of their value and 64 per cent underperformed the market. Just 25 per cent of stocks were responsible for all the market gains.
In other words, “if an investor was somehow unlucky enough to miss the 25 per cent most profitable stocks and instead invested in the other 75 per cent, his/her total gain from 1983 to 2006 would have been 0 per cent”.
Long term can be very long
Since 1900 stocks have beaten inflation, bonds and cash in every country with a continuous 113-year history, the yearbook notes, with a global basket of stocks earning 5.2 per cent annually in real terms since 1900. The US market, the biggest in the world, has never had a 20-year period where stocks did not beat inflation.
That’s the good news. The bad news is that returns vary hugely depending on when one invests. The Equity Gilt Study notes that over the past 88 years the worst average annualised 20-year return for US equities was 0.9 per cent, while the best was 13 per cent. The US has had 17-year periods where stocks, even with dividends reinvested, failed to beat inflation.
Even worse, outside the US, just three countries have avoided 20-year periods of no real returns. Major markets such as Japan, Germany, France, Spain and Italy have all suffered 50-year periods where stocks failed to keep up with inflation. Anyone who bought Austrian stocks just before the first World War would have had to wait 97 years to break even in real terms.
The situation is even more grim in reality – the above figures don’t take investment charges into account.
The solution is not to pile into “safe” bonds. Since 1900, bonds have delivered negative real returns in many major markets, the yearbook shows. Rather it is to diversify globally, minimising the impact of underperforming indices.
Behavioural expert Michael Mauboussin, writing in this year’s yearbook, notes that the S&P 500 returned an average of 9.3 per cent annually over the last 20 years, with the average actively managed fund returning 1-1.5 percentage points less, due to expenses. However, the average return earned by investors was roughly 60 to 80 per cent that of the market.
Why? Lousy timing. “Our minds encourage us to act at extremes and buy when the market is up and sell when the market is down,” says Mauboussin. “This pattern of investor behaviour is so consistent that academics have a name for it: the ‘dumb money effect’.”
Ordinary investors, perhaps, would be better off following the advice of indexing guru Jack Bogle: “Don’t do something: just stand there.”
The 2014 Credit Suisse Global Investment Returns Yearbook is available as a free download.