Weekly outlook

Sticking with stocks

By Tom Stevenson, 25 February 2009

Why investors should keep faith that equities will bounce back

Investors need an increasingly long memory to remember when equities were top dog among asset classes. The first nine years of the 21st century have served up two of the four worst bear markets since Queen Victoria was on the throne and the value of global shares is down around a third since 2000 after accounting for inflation Licking your wounds after the dreadful decade investors have just experienced, you would be forgiven for giving up altogether on shares. If you do not have the residual memory of the great bull market of the 1980s and 1990s, you may well believe that stock market investment is a mug’s game.

"If anything is certain it is that the ride ahead will not be smooth" Tom Stevenson

But the long-term track record of the world’s major stock markets suggests this is not the case. In fact it suggests that over the past 20 years we have lived through two equally aberrant periods – the most recent decade an unusually poor period and the preceding ten years an unsustainably good one.

According to the annual Credit Suisse Investment Returns Yearbook, neither the roughly 5% annual loss from shares in the last ten years nor the approximately 10% annual gain in the 1990s should be relied on by investors as any sort of guide to the future. Rather they should be looking at the average returns since 1900 which sit in between the two and probably come closer to indicating the long-term potential for an investment in the stock market.

However, thanks to the remarkable power of compounding, even this more modest annual return (about 6% a year after inflation and assuming the re-investment of dividends) has resulted in a massive creation of wealth over the past 110 years. Credit Suisse estimates that $1 invested in US equities in 1900 grew on this basis to $14,276 by the end of last year.

Even after accounting for the 25-fold increase in the cost of living over the period, shares increased the purchasing power of an investment by a factor of 582. That compares with a real increase in the value of an investment in bonds of 10 times and in Treasury bills of just three times.

The price of performance

Perhaps inevitably, that excess performance has come at a price and that price has been great volatility. Indeed the averages disguise some amazing swings in value since 1900. Take the fall in the value of the German and Japanese stock markets after the Second World War, for example – collapses of 96% and 88% respectively.

And in the other direction, the gains in the major bull markets of the 20th century were something to behold. The world index rose by 206% (in real terms) after the end of the First World War, by 255% in the 1980s and by 516% between 1949 and 1959. The 113% inflation-adjusted return in the 1990s pales into insignificance.

But that is history. What does the future hold for equity investors? They will continue to demand an excess return to compensate them for the risk and volatility of owning equities, but what is a reasonable level for this equity risk premium?

Historically, equities have given investors an annual return of around 4.2% more than a risk-free investment in cash, so a key question is whether that excess return was a simple reflection of the riskiness of shares or whether there were other unsustainable factors at work.

The brains behind the Credit Suisse research – three academics at the London Business School by the names of Elroy Dimson, Paul Marsh and Mike Staunton – believe part of the equity premium can be put down to one-offs. They think, for example, that investing in shares at the beginning of the 20th century was inherently riskier than it is today because investors were less well diversified by industry and geographically and had more focused portfolios.

Persistent premium

But they still believe that an ongoing equity premium of between 3 and 3.5% can be expected in future for investors who are prepared to sit out the inevitable ups and downs of the market.

That is less than investors came to expect in the golden age of the 1980s and 1990s but it is not to be sneezed at. Investor A earning 6% a year on his or her investments will be 40% wealthier than Investor B earning 2.5% in 10 years and twice as rich after 20 years. Over time, even relatively small differences add up to a big difference.

And remember, this analysis of the long-run potential returns from shares takes no account of the level at which an investor enters the market. As regular readers here will know, history has shown that investing after extended periods of underperformance has tended to lead to extended periods of outperformance.

Of course, no-one knows what the future holds for investors. If anything is certain, it is only that the ride ahead will not be smooth. There will be ups and downs, some of which, in both directions, will be unexpectedly violent. But as the Credit Suisse research concludes: “there are risks to being out of equities as well as in”.