Good investors are typically skeptical. They don’t buy every idea that comes their way, but they test and probe to find ideas with compelling value that are misunderstood by others. That said, the best investors are prudent risk-takers. They continue to search for good investments even in environments that seem to have a negative investing climate.
Skepticism can degenerate to permanent pessimism, particularly because most news coverage tends toward the negative. How does an investor remain bullish in the face of news flow that is predominantly negative? By looking at the broader tendencies of equity markets to flourish in the face of troubles over the long run. One good book for that is Triumph of the Optimists. [TOTO]
TOTO points out a number of things that should bias investors toward risk-bearing in the equity markets:
- Over the period 1900-2000, equities beat bonds, which beat cash in returns. (Note: time weighted returns. If the study had been done with dollar-weighted returns, the order would be the same, but the differences would not be so big.)
- This was true regardless of what presently developed nation you looked at. (Note: survivor bias… what of all the developing markets that looked bigger in 1900, like Russia and India, that amounted to little?)
- Relative importance of industries shifts, but the aggregate market tended to do well regardless. (Note: some industries are manias when they are new)
- Returns were higher globally in the last quarter of the 20th century.
- Downdrafts can be severe. Consider the US 1939-1932, UK 1973-74, Germany 1945-48, or Japan 1944-47. Amazing what losing a war on your home soil can do, or, even a severe recession.
- Real cash returns tend to be positive but small.
- Long bonds returned more than short bonds, but with a lot more risk. High grade corporate bonds returned more on average, but again, with some severe downdrafts.
- Purchasing power parity seems to work for currencies in the long run. (Note: estimates of forward interest rates work in the short run, but they are noisy.)
- International diversification may give risk reduction. During times of global stress, such as wartime, it may not diversify much. Global markets are more correlated now than before, reducing diversification benefits.
- Small caps may or may not outperform large caps on average.
- Value tends to beat growth over the long run.
- Higher dividends tend to beat lower dividends.
- Forward-looking equity risk premia are lower than most estimates stemming from historical results. (Note: I agree, and the low returns of the 2000s so far in the US are a partial demonstration of that. My estimates are a little lower, even…)
- Stocks will beat bonds over the long run, but in the short run, having some bonds makes sense.
- Returns in the latter part of the 20th century were artificially high.
The statistical chapters on the 16 developed markets are amazing, but now almost seven years dated. Still, you can glean a lot from them.
This is an expensive book, and one that may not be for everyone. A cheaper book that covers many of the same issues is Stocks for the Long Run, by Jeremy Siegel. Now going into its fourth edition (I have a signed first edition), it covers many of the same issues, but with more of a US-centric approach, and going back another 100 years (with spotty data).
As I like to say, stocks do well, absent war on your home soil, out-of-control socialism, and severe recession/depression. These books will help you stay in the market even when times are hard. After all, who can tell when the market will turn up? Or down?
Dimson, Marsh and Staunton
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Jeremy Siegel
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I have not read either book yet, but wanted to comment on some of the conventional wisdom you indicate that they espouse.
I believe that outside of going concern portfolios (endowments, pensions, insurance companies) our industry is using apples to invest for oranges. The reality is that using 100 or 80 year average returns to formulate an asset allocation strategy for people who may only have 20-40 years is a significant mismatch.
The issue I rarely see addressed when formulating asset allocations strategies is the impact of starting valuations on expected future returns. The industry hides behind the “you can’t time the market” nonsense to justify their stance, but using valuation as an input to generate a reasonable expectation of future returns is not timing – it is called investing.
From current prices, the broad equity market indexes are priced to generate very modest returns over any reasonable time horizon for individuals assuming valuations revert to mean/median levels. At this point bonds are priced very poorly as well. Most of the industry would suggest that people maintain their allocation of 60% stocks/40% bonds and hope for the best because “stocks do best over the long term”. Relative to bonds that may be the case given current valuations, but relative doesn’t pay the bills.
While I am sure some stock pickers can find the diamonds in the rough and overcome the wide overvaluation, I think people would do well to consider the reality that future returns are likely to be very low unless one adopts a more active strategy (which comes with its own risks/problems).
I would enjoy hearing David’s or other readers’ ideas on how to attack this challenge at the portfolio level for individuals.
James Dailey, IMO the argument about stocks vs. bonds in the context of time horizons should really be recast as an argument about investments with high vs. low risk premiums to earnings yield.
It’s important for investors to look at the entire macro universe of investment possibilities, rather than thinking their decision as a choice between mainly U.S. stocks vs. mainly U.S. bonds vs. dollar denominated cash. At a time when hedge funds are booming, the small investor has less need of hedge funds than ever before because he has convenient access to exchange traded products and/or mutual funds to fit most every conceivable macro thesis about where the best investment returns will be over his decision-making horizon. At the level of investment generalities, there is always going to be a positive long term return for accepting risk premiums while controlling overall risk at the portfolio level. Which asset classes have attractive characteristics for long horizon investors is continually changing. But if one insists on an even less specific view, its true that “stocks” tend to have those characteristics more than “bonds” do. But yeah, that view is too non-specific (as witnessed by early 2000 bubble in tech stocks).
“US 1939-1932” I assume this is 1929-1932.
One of the long term big picture challenges that I really don’t know how to work around is the coming population changes. America is graying slower than the other developed markets and many emerging markets, but nearly everyone has a peak in worker populations in the next 30 years.
In the 1900-2000 timeframe we had improving productivity and growing worker populations driving economic growth. Hopefully we will still have decent productivity growth going forward but it will be working against population declines which seems likely to lead to slow growth.
Also many people will be heading for the exits from equity (and other) markets as they seek to live off of their investments. On that theme as well it seems there will be a quest for safety as more people look for places to put the money during the drawdown phase of their investment lifecycle. The CDO story is as much about a reach for safety as it is a reach for yield. Individuals as well as pension fund managers are and will be looking for safe decent yielding investments in a world awash with not so safe low yielding stuff.
It seems like there isn’t a good way around low returns over the next few years.
My copy is at the office but there is a wealth of data; look at equity and fixed income returns of Japan and Germany; those stats are eye opening
Don’t view it as using 80-100 year returns, view it as seeing 8-10 data points of 10-year returns. Over *almost* any 10-year period, you get the same results. Stocks better than bonds better than cash. I believe that over ANY 20-40 year historical period, you will get the same results.
Thanks for the response Bill.
GMO actually put out a chart examining subsequent 10 year real returns by placing the SPX (and their pre-1952 equivalent) into quintiles based on monthly P/E ratios. The average average annual real return for the most expensive quintile was barely over 1% per year for 10 years. Your comment once again ignores valuation. History is clear, if one buys stocks for a buy and hold purpose at present valuations, the expected future return is likely to be 1-2% real over the next 10 years. That is not what most people I know are 1- counting on and 2- willing to sit through given the risks of owning stocks.
Another book whose conclusions and backtesting methodologies I’d like to see you review is the Magic Formula book by Greenblatt.
I left a comment that hit moderation because of a link to S&P’s website …
Let’s also add “You Can Be a Stock Market Genius” by Greenblatt and Phil Fisher’s “Common Stocks and Uncommon Profits”. Ken Fisher’s foreward about his father is particularly interesting as it is very personal; something all of us fathers can relate to with their sons and vice versa.
Bill, you might want to repost the comment, then. It looks like the spam filter ate it, and the rate of spam has gotten really high lately… in less than half a day the buffer fills, meaning that if a legitimate post goes to spam rather than moderation, my window for catching it is thin. Sorry, and I appreciate your posts here, even when they are critical.
That applies to all who criticize me here. Feel free to post, so long as you keep it clean, relevant, and civil.
Drat!
Short version and speed typing, I wasn’t answering the question about valuations, so I ignored them in my answer. Valuations matter in direct proportion to holding time. Active traders can outperform both the indices and value investors with increased activity and a plan for trading “overvalued” stocks. Let’s not get egotistical about “our” style and let’s remember that lots of styles work for lots of different folks.
What do you think valuations are now? S&P on their site says 17.7 P/E on TTM basis. What discount rate and projected growth (feel free to use a two- or three-stage modified DCF) do you think is needed to make 17.7 look reasonable? Where is your model for index P/E to 10+ year returns? Do you need to take current interest rates into account?