Four Constant Things about Markets

Each year Credit Suisse publishes a Global Investment Returns Yearbook[i].  In a world that continues to focus on short-term noise, the 2021 Yearbook provides data to help remind us about the importance of a long-term mindset when it comes to financial markets and your own financial plan.

We have captured below some of the key messages in the 2021 Yearbook.

1.       Stocks beat bonds over the long-term

The graph below show the real returns (i.e., net of inflation) by country for stocks, bonds and cash starting in 1900:

In all 25 countries studied, there is a clear relationship between risk and return.  Stocks beat bonds and cash by a significant margin in all countries. Elsewhere the report shows the average annual equity premium was 4.4% (and even higher in Australia at 6.8%).  A premium of 4.4% may not sound like much, but if you earned 0.8% on government bills and 5.2% on your equity portfolio each year for 10 years, at the end of the decade your share portfolio would be worth 53% more.  The compounding effect of the equity premium is immense over time.

2.       The long-term doesn’t matter if you can’t survive the short-term. 

Obviously, no one has an investment time horizon of 120+ years, and some may question the validity of such timeframe of data.

This is why the distribution of returns over varying time periods gives you a better sense of the range of performance:

Even 10 years is relatively short-term in the grand scheme of things as you can see from the wide range of real returns over that time frame.

This is why bonds and cash, while seemingly useless over the long-term, can be essential over the short-term.  People often misunderstand the role bonds play in a portfolio and (reasonably) complain about the current low yields their fixed interest portfolio earns.

Bonds are essential for practical and emotional reasons.

Bonds are used to either buy stocks at low prices or to fund your cashflow needs when stock prices fall.  Selling stocks at low prices is the best way to reduce the longevity of your money.  Think of your bond portfolio as representing your cashflow needs for the next 5 to 7 years.  Emotionally, this means you do not need to panic or become anxious when stock prices fall – your cashflow needs, and hence your lifestyle, are covered.

Owning bonds can be a hedge against bad decisions at the worst possible time so you can make it to the long-term with your stocks.

3.       Inflation plays a bigger role than you think. 

Look at the difference in growth between nominal and real returns in both the United States and United Kingdom over time:

The top left panel above shows the cumulative total return from stocks, bonds, bills and inflation from 1900 to 2020 in the U.S.  Equities clearly performed best, with $1 invested worth 183 times more than $1 invested in bonds.

The top right panel now compares the returns in real terms, which means net of inflation.  This shows that $1 invested in equities grew in purchasing power by 2,291 times over the 121 year period.  This compares with only 12.5 times for bonds and 2.6 times for government bills. 

Similar results were experienced in the UK, though the quantum was lower.

This is both the good and the bad of compounding. Over very long periods of time returns in stocks, bonds and even cash can lead to substantial growth.

But inflation compounds against you as well. It’s like an expense ratio that changes over time – and it takes a big bite out of returns.

This is why we say it is possible to take too much risk, but also too little risk. You have to accept risk if you wish to beat a rising standard of living.

4.       Markets are constantly changing. 

Over the last 121 years, the relative size of global stockmarkets has certainly changed:

The United States made up just 15% of global equity markets in 1900. Now it looks like Pac Man eating the rest of the world at 56%.

Britain’s share has shrunk by a factor of six. Germany and France have seen similar slippage. Then you have countries like Japan and China that weren’t even on the pie chart in 1900 but now have the second and third largest market share.

Australia has remained relatively stable, reducing from 3.4% in 1899 to 2.1% today, making us the ninth-largest equity market. However, from the perspective of the rest of the world, we remain a highly concentrated market.

Some 41% of our market is represented by banks (22%) and basic materials (19%, predominantly mining).  And our three largest stocks at the beginning of 2021 represented 24% of our entire market - Commonwealth Bank of Australia (9% of the index), CSL (8%) and BHP Billiton (7%).  This is why Stewart Partners places importance on global diversification.

It is also interesting to see how sectors represented in global stockmarkets have changed since 1900:

What happened to the railroads!

This original S&P 500 index in the U.S consisted of 425 industrial stocks, 60 utilities, and 15 railroads. Financial stocks weren’t added until the 1970s. Technology didn’t really exist as a sector in 1900. Now it dominates the market.

So while the stock market itself remains a great bet over the next 120 years or so, no crystal ball will tell you what the winning country or sector will be in that time.

This is what makes markets so hard. The general relationship between risk and reward is fairly straightforward over the long-term.  And we know from other research only 4% of the listed stocks in the US since 1926 have accounted for the entire market gain - https://www.stewartpartners.com.au/insights/2020/6/3/the-perils-of-owning-individual-stocks-more-losers-than-winners

But picking the winners within the stock market will always be easier in the rear view mirror.

 

Author – Rick Walker, with thanks to Ben Carlson’s article: https://awealthofcommonsense.com/2021/03/four-things-everyone-needs-to-know-about-the-markets/

[i] https://www.credit-suisse.com/about-us-news/en/articles/media-releases/credit-suisse-global-investment-returns-yearbook-2021-202103.html