Triumph of the Market Realists

“Genius is only a greater aptitude for patience.”

- George-Louise Leclerc de Buffon.

If it was Wednesday, then it had to be The Dorchester, where Citywire held their latest wealth management forum. Keynote speaker was Elroy Dimson, Professor of Investment Management and a Faculty Governor at the London Business School. Students of the markets will also know Dimson as a co-author of the magisterially weighty Triumph of the Optimists: 101 years of global investment returns (Princeton University Press, 2002) alongside LBS colleagues Paul Marsh and Mike Staunton. You can read the 2009 updated commentary here.

The 21st Century has not, so far, been kind to equity market investors. Real returns across the major markets over various long terms can be seen below:

Real equity returns 2000-2008 and over a longer run

Source: Elroy Dimson, Paul Marsh and Mike Staunton, Credit Suisse Global Investment Returns Sourcebook 2009 and Triumph of the Optimists, 2002

We “know” that over the long run, equity markets reward the patient investor. An investor in US stocks would have enjoyed average annual real returns of 6% over the course of the 20th Century.

But an investor in almost every major market since 2000 is currently staring unbelievingly at an alarming succession of losses. The worst bear market in history stands as the Wall Street Crash of 1929-1931, where the world index fell by 54% in real, US dollar terms. Even more extraordinarily, we are still within a whisker of that loss. As Messrs DMS point out:

The peak to trough real return during the current banking / credit crash stands at -53%. If the current remission falters and we hit new lows, it could yet become the worst bear market on record. In its short nine-year life, the 21st Century already has the dubious honour of hosting two of the four worst bear markets in history.

We can debate the identities of the guilty parties (bankers? real estate salespeople? regulators? lobbyists? ourselves?) indefinitely. What we cannot, or should not, do indefinitely is try to avoid some of the more telling conclusions.

Spoilt by the “golden age” of the 1980s and 1990s, the modern investor is still overly obsessed by the allure of common stocks. This is a theme we have reiterated at each of our last two summer investment seminars, as shown in the chart below:

Q: Why do so many financial advisers (and fund management companies) promote stocks?

Source: Global Financial Data, Datastream

A: Because they worked during the most recent 20 years.

The chart is explicit and compelling. Arranged by two-decade periods since the start of the 18th Century, the history of the UK stock market looks more or less like the proverbial bell curve of economic theory (and myth, as regards the fat tail volatility of real investment world returns). After inflation, the 20 year returns from the stock market cluster either side of zero. There are, worse still, numerous 20 year periods when stocks delivered negative real returns. But every cloud... Standing stark and alone at the right side of the chart is our old friend 1980-1999, the one huge outlier period when the market delivered 20 years of annualised real returns of between +8% and +10%. Such performance may happen again, but it has certainly never happened before.

Investors extrapolating from the recent past as they entered the new millennium were, let's be honest, pre-destined for a world of disappointment.

Independent but related to this conclusion is the next common-sense investment strategy: don't keep all your eggs within any one asset class basket. That holds whether the basket in question holds property, stocks, bonds or anything else. Outside the context of a full-blown deflationary depression, Messrs DMS also point to the paucity of returns that come from sheltering in either Treasury Bills or cash:

Real returns on equities, bonds and bills, 1900-2008

Source: Elroy Dimson, Paul Marsh and Mike Staunton, Credit Suisse Global Investment Returns Sourcebook 2009 and Triumph of the Optimists, 2002

The chart is instructive. Over the admittedly long run, bonds lag behind stocks in each country. Treasury Bills lag behind both, and in a number of incidences were wealth-destructive over a very long period. (Don‟t entrust your assets to the government, Mrs Worthington.)

The figures cited by Messrs DMS above all relate to indices. But as is widely known, active fund management comes with its own risks. As Yale Endowment CIO David Swensen has written:

Most mutual funds do not produce even minimally acceptable results because of the conflict between the mutual fund company's profit motive and the mutual fund manager's fiduciary responsibility. Mutual fund companies profit by gathering assets, charging high fees and churning portfolios. Mutual fund managers produce superior investment returns by limiting assets, assessing low fees and trading infrequently. In case after case, profits trump returns. The mutual fund manager abrogates fiduciary responsibility for personal gain.

All of which does not necessarily invalidate the managed fund proposition, rather it requires discernment and a degree of due diligence to discriminate between those fund management groups with the potential to add value to a balanced portfolio and those charging egregiously for performance (either historical or prospectively with a high likelihood to be) inferior to an index. It may, furthermore, not be rational to pursue the index if active management offers the potential to moderate losses – easy to say, admittedly, in the aftermath of the last decade's lamentable performance by common stocks. But if nothing else it absolutely reinforces the requirement for fund managers to be competitive in pricing their products – which tend to be aggressively promoted rather than necessarily actively sought.

But there are pockets of light amid the gloom. The choice for the open-minded investor is wider than it has ever been, and now includes products such as low cost exchange-traded funds which offer cheap investable access to index returns. And the UK regulator, via the Retail Distribution Review, has just sounded the death knell for commission-heavy products. Within the not too distant future, fund managers will have to justify their existence through performance rather than bribes to distributors. Perhaps most important of all, however, is following a path that is likely less well travelled: ignore the indices but embrace asset class diversification and build your portfolios from the bottom up, following the principles of deep value in pursuit of capital preservation and absolute returns. One obvious response to the DMS data is to assume that since the post-2000 period has been such a bust for traditional investments (specifically, equities), the outlook now is bright. It is still impossible to say, but that looks like a premature if not dangerous conclusion to draw. To paraphrase Keynes, markets can stay bearish longer than you can stay patient.

Realism wins.

Comments

[TradingHelp...:]

"We can debate the identities of the guilty parties (bankers? real estate salespeople? regulators? lobbyists? ourselves?) indefinitely. What we cannot, or should not, do indefinitely is try to avoid some of the more telling conclusions."

I agree stocks performed well on average to 2000, but the growing emphasis on debt, its loose availability and its mis-use for speculation and consumption - borrowing from future income, has created a financial industry and economy that is now fundamentally flawed.

When we use debt, or excess money supply for consumption or financial speculation it, as we have seen, creates bubbles and inflation. Only when excess money supply is directed towards projects that create new streams of economic value can we secure real and sustainble economic growth.

And of course, referring to your excellent charts, past performance is no guide to future performance.

As always, I am a great admirer of your articles, thank you.

Jul 05 06:29 AM

[Prudent Man...:]

I have yet to hear or read anyone with any credibility, which by definition eliminates all Crony Capitalists, political economists, academics, politicians, Wall Street cronies or "journalists" (p/k/a reporters until they became editorialists) who can provide any substantiated documentation as to where economic growth in the U.S. will manifest itself let alone when. The point is that we are at a comparative cost disadvantage because of tax policy and "cap and trade", which will exacerbate that reality and put us completely out of the international economic competitive business.

I have trouble understanding what can be done in the U.S. that cannot be done in a more cost advantaged nation. Our creativity is stymied by politicians of both parties financed by statists and the political elite.

Why propagate self-destruction is beyond my comprehension. The economic advantages we had from WWII until the end of the twentieth century are gone. A new productivity paradigm is required A return to Free Enterprise with Congressional Term Limits would help stimulate our creativity and productivity.

Jul 05 10:39 AM