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Rethinking 'equities for the long run'
Investment Strategy | 17 Comments | Sat 24 Mar 2012
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One of the bedrocks of investing is that equities (riskier assets) outperform bonds (safer assets) over the long run – certainly history has borne this out. However, as we know, accepting investment ‘received wisdom' can be very dangerous. This article explores an alternative view.



Comments

1.
On 26/03/2012 19:51:30, James East wrote:
I am skeptical of stock performance numbers that economist and others use. Over the very-very long term, I would suspect that equities have probably done better than debt, but not by as much as the numbers quoted would have one believe. How does one add/subtract the survivorship bias? Recall that the indices we see are only the survivors, When a stock in an index goes to zero, they just replace it with another stock.

One would not have to stretch too far to ask if this is the reason it is so hard to bet and index. They get to toss out their losers, oh, if I could only do that :)

Cheers
JEast

2.
On 27/03/2012 11:53:46, Gary Connelly wrote:
Thanks for the comment James.

Not sure you're right in stock market indices exhibiting a survivorship bias. True, indices tend to cull companies in decline, but they factor in (the presumably negative) performance up to the point of omission.

In fact, it could be argued that the performance of indices is held back by the regular culling of underperforming stocks, because yesterday's poor performers tend to be deeply out of favour and are more likely to subsequently perform well. I can't point to any 'proof' that this is the case, just a hunch.

Gary

3.
On 27/03/2012 12:23:26, John Mc Elligott wrote:
Dave - interesting article. I would issue a few points.

(1) It really is only in the anglo saxon world that investors still retain a large asset allocation weighting in equities. It is certainly not the case in my experience in continental Europe, or more to the point in Japan.

(2) I have come to a conclusion, that equities are only a worthwhile investment if one can find a combination of mispriced quality - that is the belief that some form of mean reversion in terms of margins, returns and ultimately valuation is likely. In the absence of that, I am not sure that equities are that interesting an investment. Check out

http://www.crestmontresearch.com/docs/Stock-Secular-Chart.pdf

4.
On 27/03/2012 12:26:59, David Coyne wrote:
Thanks John, your first point is well-made. Though I would say that the recent past tends to be a big influence on how people invest. In the case of Japan, equities have performed dreadfully over the last 20-odd years, so it makes sense that equity ownership is low (much like in the US post the Depression). As far as I know equity ownership was wide-spread in Japan in the 80s. As for Europe, not sure -- perhaps the memory of two world wars?

As for your second point, I guess that's somewhat along the lines of what I'm thinking also! But this is all very complicated stuff. I'm trying to keep my mind open to all viewpoints. Thanks for the feedback.

5.
On 27/03/2012 13:31:01, David Coyne wrote:
See below a Consuelo Mack interview with Lubos Pastor of Uni­ver­sity of Chicago pro­fes­sor. Here he discusses the central point (stocks for the long run) of our article, among other things.

http://advisoranalyst.com/glablog/2011/08/15/pastor-rethink-stocks-for-the-long-run-uncertainty-compounds-with-time/

6.
On 29/03/2012 14:45:48, Graeme Kyle wrote:
Thanks for the article lads. Makes a good case for heavier allocation into alternative asset classes, particularly absolute return funds and possibly also commodity funds. Any thoughts on how long the current de-levaraging trend will last and the level at which debt/gdp will trough?

7.
On 30/03/2012 10:49:28, David Coyne wrote:
Graeme, the article wasn't intentionally making the case for alternative asset classes, but maybe that is something to consider. At the end of the day, investors should buy what's good value for the risk entailed (properly considered), regardless of its structure or how it is classified. The article's primary point was to pick a hole in investors' structural positive bias favouring equities, on the expectation of superior long term returns.

Regarding the current de-leveraging trend, I wouldn't be so naive to think I can guess how things will play out. Let's face it, there is massive central bank manipulation in financial markets through deposit guarantee schemes and countless other distorting factors that bail out both providers of debt and the risk takers -- not to mention the unknowable consequences of the current quantitative easing programs. The article mentioned the increased leverage in the system to highlight that the turbo button has been held down for the last few decades (at least). The turbo button cannot be held down indefinitely. De-leveraging would clearly have a negative effect on global economic growth and returns for shareholders. But even simply maintaining leverage at its current high level would likely too result in a slowing down of growth and returns versus the past.

I hope that this makes sense and helps!

8.
On 30/03/2012 14:31:48, Paul McNulty wrote:
The article mentions the 'emotional tax' on the average fund investor, who tries to time his way in and out of the market.

The following link, highlighted by the guys from Metropolis in their most recent Value Investor Digest, shows just how high that tax can be, using the example of CGM Focus fund.

http://online.wsj.com/article/SB10001424052748704876804574628561609012716.html?dm_i=O75,QZGJ,3OL163,26G48,1

9.
On 30/03/2012 15:04:03, Conor Maguire wrote:
Very interesting article, thanks for sharing these ideas. Upon reading it, my initial response is that I’m not sure I agree with the view that at a theoretical level, expected returns on all asset classes should be equal, and furthermore that it is illogical to assume that equities should return more than bonds over the long run. I would argue that this view ignores three key considerations:
• Bond returns are, and will always be fixed, in the sense that regardless what price you pay to hold a bond, the most you can ever expect to recoup is par value; by contrast, equities offer the prospect (theoretically at least) of unlimited returns in terms of potential for capital gain.
• Bonds (at investment grade level) are generally speaking, stable income producers for their holders. In light of this, this reliability or predictability is prized by pension funds etc. for the certainty it affords them as investors.
• Finally, the argument put forward, in my view, ignores the risk profiles and preferences of investors; some investors are not looking for stable yields or bond-like returns, but seek out for example, multiples of capital available for investment (VCs for example); so it does not necessarily follow that expected returns across asset classes would equalise by capital flowing out of bonds and into VC funds or other prospective higher-return investment opportunities.

10.
On 30/03/2012 22:01:58, Paul McNulty wrote:
Dave,
On the rationale for higher expected returns and the possibility that this comes down to riskier assets tending to be more volatile - the data from Dandar, and indeed too from the link provided by the Metropolis lads above, is fantastic. Im not sure its appropriate to compare the number to a bond fund.
Why would investors in a bond fund be any less likely to buy at the top and sell at the bottom than investors in equity funds? Indeed, aren't these the same investors? Shouldn't we compare the volatility of equities to that of a bond matching the duration of an investor's time horizon (or liabilities)? The investor has a choice, a (in theory) sure (nominal) return, or the hope of the higher returns that may accrue to providers of capital lower down the capital structure.

11.
On 03/04/2012 18:43:35, David Horgan wrote:
Gary,

Thanks for the article, very thought provoking. Why do I get the feeling that the author(s) of the article are being a little provocative and actually do not believe in the thesis of the article.

I agree with Conor McGuire here, I do not believe all asset classes return the same over the long term. Why should they? In the case of bonds v equities for instance this would imply that investors do not value dependable returns (& income) in bonds versus the unknown in equities. Yet we know both intuitively and otherwise that this is not so. Similarly for cash, investors 'pay' by accepting lower returns by deposit holders for the luxury of access to capital. On the other end of the scale leveraged property is rewarded both for its inherent risk (bar in the last 7-8 years mind!!) and its illiquidity. That's why commercial property for instance should always have a yield premium- as it needs it to justify its price to investors.

I think the article is interesting in exploring the idea that things like volatility in returns & income will not command a return premium, but the fact that this is so counter intuitive to common sense should in itself give a summary answer to its thesis, interesting as it is.

As the old saying goes ' one in the hand is better than two in the bush' , investors pay for the certainty of one in the hand as most investors want this more & supply & demand dictate that will be more expensive and hence offer lower returns over the long term.

12.
On 04/04/2012 09:08:54, Gary wrote:
David
Yes, I struggle to reconcile my common sense assessment with the thesis of this article. I think equities must offer the prospect of higher returns to compensate for the periods during which an equity investor gets completely wiped out, and for the ocassions which are less damaging but deliver significantly negative outcomes. However, I do recognise that what the article is saying is that I have been conditioned to expect this based on the 'short' 150 year (or so) history of markets which has turned out to be good on balance for equities. The premise of the article is that this doesn't have to be so in the future. Maybe the future we will not be so accommodating. This is not my central thesis for the future, but the article has certainly got me thinking and stirred the debate. In that at least, it has been a success!

13.
On 04/04/2012 14:41:04, David Coyne wrote:
Conor Maguire / David Horgan,

Of all the articles written so far by the team, this one has undoubtedly caused the most internal debate (among VII board members). Your concerns about its logic have been voiced on more than once, in a heated fashion on occasion.

Daniel Kahneman, cognitive psychologist and Nobel prize winner in Economics, warns people against "theory-induced blindness: once you have accepted a theory and used it as a tool in your thinking, it is extraordinarily difficult to notice its flaws" (a quote from his recent book Thinking, Fast and Slow).

So David, you rightly picked up on the author's uncertainty on the subject matter, which is why the concluding paragraph asked "readers to consider this article as thinking-in-progress". But don't think that I was just trying to be provocative for provocativeness sake -- it was to challenge conventional wisdom.

I agree it seems strange to imagine an investor buying uncertain equities over safe bonds for the same return. But if the superiority of equity returns is such a 'gimme', why ever hold boring bonds?

Fellow board member Rowan Smith described the core of the article -- extrapolating good historic equity returns -- as follows. Imagine the all productive assets of the world being owned by one company. These assets are financed by bonds and equities. Bond holders receive their fixed return, to the extent that the company can afford it, while owners of the equity receive whatever is left over. If prospects for the world improve, equity owners will do well; conversely, if the world economy dis-improves equity owners will do poorly (and worse than the fixed-return bonds holders). Is it so hard to imagine this happening?

Lessons from history tend to be drawn from the U.S. This is dangerous -- it's been the most successful example of prosperity over the last 150 years. For perspective, consider that 150 years ago many Europeans looking to settle in the 'New World' considered Argentina an equally attractive destination versus the U.S. Historic equity returns for Argentinean investors would tell a greatly different tale, I am sure.

Another point worth mentioning is that we can't even be sure what historic equity returns have been: different studies quote different returns, questionable pricing of securities, questionable index calculations. The following link to an FT explains this in more detail:

(Maybe this addresses some of the issues James East referred to).

http://www.ft.com/intl/cms/s/0/51789cb8-72a4-11e1-ae73-00144feab49a.html#axzz1r3h4ycJJ

David

14.
On 04/04/2012 15:30:45, Rowan Smith wrote:
Let’s forget about actual experience as this has depended on actual outcomes which is actually besides the point: our problem is theoretical: what to expect before the events occur.



It is probably fair to say that there is some preference for less volatile assets, that is to say that most know they cannot tolerate the volatility of equity over multi-year periods and will opt for the lower returning debt rather than equity capital. This skews expected returns down for bonds, and up for equity. This is probably one reason why those investors who are intelligent, rational and have genuinely long-term capital can expect to earn excess risk-adjusted returns, by taking advantage of the returns others simply aren’t willing to risk waiting around for. Let’s put this aside for a minute.



Let’s clarify that it is the productive assets that generate returns, not debt or equity (these finance the assets). Let’s assume that those assets are financed by either debt (senior) or equity (junior). Ignoring behavioural factors, rational investors will only invest equity capital if they believe that ex ante risk-adjusted returns (as calculated rationally, objectively and with full knowledge of all potential outcomes) will be superior to debt. If these investors believe that these objectively assessed risk-adjusted returns are not likely to be superior, then they will refrain from investing equity en masse, thereby facilitating a rise in ex ante objectively assessed risk-adjusted returns until such a point as the expected return premium (over debt) is adequate. At this point they will invest. Thereafter depending on outcomes, actual, experienced returns may be much better (USA) or worse (Argentina), but again this is besides the point.



Example;



Productive Asset “X” is expected based on an objective assessment (again, intelligently and objectively assessed, ex ante, risk adjusted), to produce risk adjusted return on capital of 10%. If the cost of debt is 6% and the asset is financed 50/50 debt/equity, then the return for equity will be 14%. Let’s assume this is deemed adequate for equity investors. So as long as investors believe that the properly assessed risk-adjusted returns of 10% on productive assets can be sustained, then the margin of safety for equity capital remains adequate (14% versus 6%). At some point below 10%, equity starts to look less attractive than bonds and equity capital dries up until returns rise again to 10%, restoring the RoE to 14%. The 10% is not relevant, but you get what I mean.



Now none of this explains why many investors, zombie-like just assume that equities get a higher return because they are riskier. Higher risk in itself guarantees nothing. The whole matter hinges on the profits that can be generated by the productive assets. The point is that equity capital will only be made available if the ex ante, properly assessed, risk adjusted returns on assets are deemed adequate to offer the legitimate prospect of a return premium. In the absence of this assessment, capital withdraws until the returns rise to adequate levels again.

Overall a very interesting topic to continue to contemplate.

15.
On 19/04/2012 17:41:17, David Horgan wrote:
Rowan,

That's a very thoughtful and intelligent comment. There is a lot in it.

With regards to equities providing a 'most likely' premium over bonds or other assets there are some fairly fundamental factors at play for equities IMHO:

1. Institutional investors in particular, have a bias towards bonds & this gives equities an inherent return premium (by the market mechanisms Rowan explains so well above)

2. There is a significant part of the market who cannot or will not tolerate the inherent volatility in equity returns such as those nearing retrement age, defensive investors (e.g. currently in Europe, Japan, etc), or just the plain cautious by nature. This again pushes up the return premium that markets offer to equity investors on average.

3. Of course Equity returns will not always out pace those of Bonds or other assets. In the short term this can be due to volatility but over the medium term this is most likely to be caused by over paying for equities in the first place e.g. current US CAPE valuation levels are ~20-22 and historically CAPE is ~16 so the US market is currently overvalued by approximately 25%. This is not a market that is likely to give above average returns, as any investor is paying 25% more for earnings than has been done historically.

As for one of the central points of the original article that equities have enjoyed a better than average 150 years of prosperity to fuel their returns, due to the fantastic rise of the US, the industrial evolution & the internet, etc, etc. Yes but equities have also had to tolerate 2 world wars, the threat of nuclear war, environmental concerns, famines and all sorts of other issues (e.g. peak oil).

The real question to be asked in that context is the next 150 years likely to be less, equally or more prosperous?

My bet would be on more prosperous, on the simple basis that populations are rising with education and standards of living rising even faster. These demographics & trends incorporating 1-2bn Chinese and 1 bn Indians in particular make a compelling case for achieving good returns when investing in decently priced equities that can benefit from these trends over the 'long run'.

Is that naive, too simplistic, or just plain common sense!?

16.
On 20/04/2012 22:11:53, John Looby wrote:
David,

I think the systematic behavioural biases studied by the likes of Kahenman is a rich area for grappling with these issues.

In particular, I wonder is the asymmetric psychological / physiological reaction of the collective 'investor' to risk versus reward a lot to do with it i.e the fact that we are apparently hardwired to get one positive endomorph kick for a positive, but two or more in the opposite direction for an equivalent negative - so we are collectively risk averse, tending to give an ex-ante premium to the 'riskier' asset?

Taleb (in Fooled by Randomness) tells a nice story about the dentist / amateur investor who, after a period of exceptional investment performance, makes the decision to jack-in dentistry and become a full-time investor with some interesting psychological / physiological results, as he's now exposed to the vagaries of his portfolio with much greater frequency!

17.
On 17/05/2012 08:58:58, search engine optimization lexignton wrote:
That was really interesting!

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