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.
A different model
Stockbrokers, rich themselves like their clients, knew that investment was about purchasing income [on which to live], as well as gambling for fun, and gain. This was the basis of what was later known as the Fed model: 40 per cent bonds for living expenses and 60 per cent shares for lower income and some hopes of capital profit.
The reality of investors’ desires is evidenced by the history of the past 10 years. The more that central banks pushed money into the markets, driving down yields on cash and safe-as-cash investments and pushing investors to buy more equities, the harder investors looked for high-yielding returns – whether from junk bonds, new types of investing such as government guaranteed infrastructure projects, or lumpy and illiquid investment sources such as aircraft leasing, green energy, or even artistic royalties.
The illiquidity risk (should have) persuaded investors to purchase these types of assets through closed-ended funds, rather than open-ended products such as unit trusts, and indeed this decade has seen a remarkable flowering of investment company issuance.
But the original buyers of this type of investment manager have another lesson to impart for today. They knew that regular income each year was what kept them rich, and income from bonds was surer than dividends and capital growth from shares. The Journal of Financial Economics study shows the same is true today.
The F&C philosophy
In the latter part of the 19th century, newly rich Europeans needed income in excess of that which was available from developed world bonds. What’s more, they also needed a growing income – whatever we believe now, inflation was a problem back then. The managers of the F&C trust, launched in 1868, came up with an answer that was then followed by their successors.
Their solution was as follows: buy the high-yielding bonds of emerging market economies (in those days the US, British empire countries such as Australia and India, or even South American republics), at a sensible valuation (such as 6-8 per cent at a time when gilts were selling at 3 per cent), check out long-term prospects, and diversify between countries and regions.
To this they added a focus on garnering income, then appended a little excitement with shares such as US railways. They were also sure to never forget the compounding effect of a growing income, and so never took risks of a capital loss.
Modern relevance
For those readers who cannot believe that such principles have any relevance today, a look at the portfolio and record of the Personal Assets Trust will persuade them otherwise. Investment is about portfolio design, based both on today’s and tomorrow’s circumstances, and the agreed objectives of managers and clients combined. The efficient market hypothesis may keep pension fund trustees entranced, but it wont make them rich.
Practical investors are risk averse, however risk is defined. And British investors are facing levels of risk unprecedented since 1940.
A modest-sized economy is launching itself into a trading world that has consolidated into warring trading blocs. It has demerged itself from one such neighbouring group with a definite decline on GDP growth, and is now so politically split that the future cannot be predicted.
Compounding is about patience but also avoidance of unnecessary loss. The FTSE may be cheap, or even good value, but since nobody can agree on the country’s future, the outlook for UK asset prices is unverifiable. Best to diversify internationally through global investment managers such as F&C, Witan or Alliance Trust.
Safe, rather than sorry, is the watchword of the best of the old-style investment trust managers, and that should do for us at this tricky moment.
