Blog #30 Why I Love History

I’ve used the phrase “invest for the long-term” on numerous occasions and this is for a good reason. In the short run, almost “anything goes”, making it hard to predict market returns. The difficulty arises because investors are trying to sort out the implications of news, be it economic, political, or policy. Digesting news takes time. This is complicated by the fact that there are investors who trade short-term for liquidity or speculative reasons and not because of economic fundamentals. As a result, returns measured over days, weeks or months are extremely “noisy”.  This is why to understand risk and return, we must examine long periods of history.

How long is long enough? That is a hard one to answer. Suffice it to say that even over periods as long as 20 years, we can still observe “unusual” returns. The period from 2000 to 2016 is a good example. According to the Credit Suisse Investment Returns Yearbook (2017 edition):

“The 21st century began with one of the most savage bear markets in history. The damage inflicted on global equities began in 2000, and by March 2003, US stocks had fallen 45%, UK equity prices had halved, and German stocks had fallen by two-thirds. Markets then staged a remarkable recovery, with substantial gains that reduced, and in many countries eliminated, the bear market losses. World markets hit new highs at the end of October 2007, only to plunge again in another epic bear market fueled by the Global Financial Crisis. Markets bottomed in March 2009 and then staged another impressive recovery. Yet, in real terms, it took until 2013 for many of the world’s largest markets to regain their start-2000 levels.”

The Credit Suisse Global Investment Returns Yearbook is an indispensable guide for serious investors who want to understand the forces driving long-term and shorter-term market movements. The Yearbook charts the investment returns of inflation, currency and three of the most popular asset classes: cash (represented by Treasury bills), Treasury bonds, and stocks. Returns for each asset class go back to 1900, providing a long sweep of market history and a useful antidote to investor “short-termism” so prevalent in today’s world.

The Yearbook’s geographical coverage is broad. Specifically, returns are shown for 21 countries with complete market history spanning North America, Asia, Europe and Africa, In addition, data is presented for two aggregate world equity market portfolios: a World portfolio (denoted by ‘W’) comprising all 21 markets and a World equity portfolio that excludes the US (WxU).  The major markets are shown in the chart blow.

CS Yearbook 2017_Countries.jpg

A common mistake by investors is to single out best performing markets and use their past returns as a guide for the future. This is a mistake because we only know from hindsight which markets won the race. In doing so, we forget the wisdom that “past returns are not a guarantee of future performance”.

The cure for hindsight bias is to pay more attention to a globally diversified portfolio. For this reason, the W portfolio offers a more balance guide for forming expectations of future equity risk premium. The chart below plots the average annualized real returns of W from 1900 to 2016. Average returns for individual country’s equity, bonds and bills are also shown for comparison.

CS Yearbook 2017_Returns.jpg

We see that stocks outperformed bonds and bills in every single market. This is a comforting reminder that we should not invest with a hurry, but should give time for stocks to reward us with the equity risk premium (the long run average excess return of equities over less risky assets). Admittedly, none of us have an investment horizon of 117 years, but 20 to 30-year horizons doable if you start investing early. These should be the time frame for planning your investment.

The three best performing stock markets over the 117 period are: South Africa, Australia, and US. South Africa is a surprise. Australia lived up to its fame as the laid-back “lucky country”. However, there are no surprises for the US: a strong survivor market which continues to play major leadership roles on the global stage. The average yearly compound return for these markets is at least 6.4% and this, after inflation!

As I said earlier, it would be a mistake to base your predictions of the future on best performing markets. Far better to use the investment history of the global diversified portfolio, W. This portfolio earned a respective average real return of 5.1%. Moreover, W has a lower volatility (17.4%) compared to the US (20%) even though the US was the dominant market in W since the early 20th century. This is the benefit of diversification.

What does an average return of 5.1% mean in terms of a dollar invested over 117 years? Answer: $336,913. This is how much a dollar in 1900 is worth after inflation when compounded at 5.1% a year over 117 years. In contrast, one dollar invested in bonds (average real return: 1.8% a year) increased to only $8.06. The difference in terminal wealth outcomes between stocks and bonds is mind-blogging and not intuitively obvious from the seemingly small difference in annual return of just 3.3% between stocks and bonds (5.1% minus 1.8%). This is the fabled magic of compounding! Many investors only care about “last month’s returns”. These investors are choosing to throw away decades’ worth of compounded wealth.


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