Russell Taylor: Why investment has much in common with the lottery

Russell Taylor: Why investment has much in common with the lottery

Equities always outperform bonds over time. This is the core belief of all investors and the CAPM, or capital asset pricing model, is at the heart of modern investment theory. 

There is an extra return from holding equities, but also a greater risk of loss, so buying prices must be adjusted to account for this. Indeed, there is hardly an index that shows the opposite; none at all do so over any decent period of investment time. Consequently, the findings of a new analysis of the performance of 26,000 stocks in the New York Stock Exchange, Nasdaq and Amex, published in the Journal of Financial Economics, should concern private investors.

The study covers 90 years – rather longer than the normal investment view – and is based on the buy-and-hold strategy often recommended to private investors for its simplicity and cheapness. 

The results are not encouraging. Over these years, only 42.6 per cent of shares did better than short-term US Treasury bonds. Discouragingly, the entire excess return produced by shares over this period was down to just four businesses.

How best to recognise those winners? It is easy to forget that companies, like humans, have a life cycle. The median life of these 26,000 companies was just seven-and-a-half years. Of course, those who survived longer became bigger, more successful and profitable businesses, but who can predict in advance those who make it to the status of a Proctor & Gamble, or Nestlé, and those who remain and die an ‘also-ran’?

How it happened

But why should this be so when indices show so clearly that equities outperform bonds? It could be due to the costs and trading expenses charged by professional managers, or more likely because of their habits of portfolio concentration – meaning they held too many of the would-be greats and not enough of the few successful companies. This is the basic argument made by those who say private investors should concentrate on passive index investing and eschew any form of active investment.

The study also had other worrying findings. Comparative results over the nine decades of the research showed that investors have only had a one in two chance of doing better with shares than bonds in any given decade – even when dividends are reinvested. And results have got worse in more recent decades.

A key to this conundrum can perhaps be found in earlier investment thinking, before professors, stock market price series, and computers came together in the 1950s. The theories that emerged from these studies emphasised the scientific rationality of stock market pricing, thereby encouraging hard-bitten business bosses to entrust the management of their pension funds to a new breed of asset managers. 

Unlike the stockbrokers of old, these managers took the view that risk essentially involved doing worse than alternative asset allocation choices on a relative basis, rather than losing capital and income. As a result, the eternal portfolios that were thereby conceived had rather different needs from investors worried about family funds and fortunes.