While equities have been best-performing asset class, outperformance is only negligible at best and ignores share performance of firms which have gone bust
Connoisseurs of financial history will find plenty to enjoy in 'Triumph of the Optimists,' a new book by three London Business School academics, Elroy Dimson, Paul Marsh, and Mike Staunton. For example, in 1900, Russia accounted for 11% of the global value of equities, the same as Germany and Japan combined.
They will find a provocative lesson as well. Over the last century, equities have not produced anything like the returns investors have usually assumed. Nobody should expect great returns in the new century either. Shares as an investment have been consistently over-rated.
The timing of this attack is good. Last month, Barclays Capital published an annual survey of the returns from different classes of assets. This year, it found that corporate bonds provided the best real returns, not just in the last year, but over the last decade as a whole. Government bonds were the next best asset class. Equities performed relatively poorly.
Late last year, Boots caused a stir when it moved its entire pension fund portfolio out of stocks and into bonds. That switch involved dumping £1.7bn of equities. Other big British companies haven't moved that far, but are shifting the balance of their portfolios.
Imperial Chemical Industries, for example, raised the percentage of bonds in its portfolio to 70% from 50%. Marks & Spencer now has 35% of its pension fund assets in bonds compared with 20% a year ago. The Edinburgh-based research company WM reported in December that British pension fund managers now have the lowest percentage of assets in equities for any year since 1984.
The cult of the equity, and the received wisdom that over the medium-term shares will always outperform any other potential investment, is looking under more sustained threat than at any time for the past two decades.
Anyone who held shares in the likes of Enron, Global Crossing, Railtrack, or Energis will have learned the hard way over the past few months that the risk premium attached to equities is more than just a concept kicked around in corporate finance courses at business schools. They have watched bankers and bondholders walk away with big companies while shareholders get nothing.
All of which prompts this question: Are stocks about to go out of fashion?
The evidence produced by Dimson and his colleagues is striking. They have spent a lot of time flicking away dust in libraries. That is dull work, but it usually pays off. Their starting point is that most historical indices of the performance of UK equities are flawed for two reasons. One is 'survivorship bias.' Most indices calculate the returns on those companies that survive, neatly forgetting about those that went bust. That inflates returns. The second is 'easy data' bias. Most indices collect the data that is readily available, not what investors actually own.
To correct those mistakes, the authors took a truckload of old copies of the Financial Times, and calculated their own indices for the performance of different classes of investment. They found that existing data significantly overstated the long- run return on equities. In the first half of the 20th century, earlier studies had suggested a real annual return of 8.8%. They calculate it at just 3.8%. For the century as a whole, they calculate the return at 5.8%, much less than the 8-10% usually assumed.
They also examine similar re-calculated indices for the biggest 16 markets around the world. Sweden is the best-performing in the 20th century, with real returns of 7.6% per year, closely followed by the US, with a real return of 6.7%. (That's the kind of statistic that could make you give up trying to figure out economics ' no two economies have been run more differently than Sweden and the US). Again, those are lower rates than earlier estimates, and a much narrower margin over the performance of bonds.
The overall conclusion of the book? 'While the real returns on equities have been higher than bonds or bills, the margin is smaller than many investors have perceived,'' they write. Overall, they say equities outperformed bonds by an average of 3% globally over the century, which they regard as a very narrow premium for the risk involved.
There is a whiff of bear market pessimism about the attacks on stock-market investing now being made. Just as at the height of the bull market, when there was a living to be made from predicting the Dow Jones Industrial Average would soon be at 40,000, so there is now a demand for intellectuals who can explain why investing in shares was never such a good idea after all. The market, as equity specialists know better than most people, abhors a vacuum, and right now pessimism is the only bull market around.
That shouldn't blind anyone to the force of the argument being made. Most empirical data focus on the decades since 1950, which just happened be a golden era for stock markets. Worse, most data looks at the couple of decades since 1980, when most prices started to be stored electronically, making them easy to retrieve and analyse. However, those decades, of course, were a golden age within a golden age.
These issues are more than just academic. As Keynes observed, most of us are slaves to some dead economist. The intellectual mood determines the state of the market more than is often realised.
The idea that equities significantly outperform other types of investment has influenced the structure of every portfolio in the world, and directed the flows of capital through the market. It was reinforcing: everyone believed equities yielded the best returns, they invested more, and price went up, boosting those returns.
If the idea gets around that equities have never been quite what they were cracked up to be, that will have just as powerful an impact. If it takes root, prepare for a long bear market.
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