Many people advise not to focus on details. “Look at the whole picture”, they say. The same argument is brought about equity returns. Even after witnessing one of the worst drop in equity markets at the advent of this century, many analysts are still convinced that aside from instant fluctuations the picture is optimistic in the long run. The relevance of such statements is specifically significant as equities are believed to be rewarding for the risks they offer. How many times such situation was witnessed in films, when stocks bought in companies offered long term returns and unbelievable fortunes that were worth the wait. Someone said Forrest Gump? The point is that no one is secured from risks associated with such types of investment, considering the promised lucrative rewards. However, the statement that the present article will try to prove is that those rewards are highly overestimated, and in the long run the return on equities are not high as they are believed to be.
One of the reasons for the overestimation of equity returns in the long run are claimed to be the unique economic history of the United States. An argument cannot be made when the historical support for such claim is based on a unique case of country that had an extraordinary growth for over a century, growing from 22 percent of the value of world equities in 1990 to 54 percent more than a century later (Dimson, Marsh, & Staunton, 2004). Indeed, analyzing historical data of annualized returns on US equities over a period between 10 and 103 years show that for a period of 20 years and more real returns are positive. Such returns’ average is close to “Siegel’s constant”, a value coined for a stable long-term annualized real return on U.S. common stocks in Siegel (2002) (Dimson, et al., 2004). Such value is not the comparatively astronomical 10-12 percent, but it is nevertheless, positive. However, it is related to the case of US equities which were denoted as unique.
Was the return of other countries much worse during the same period? Well, it actually was. Compared to the US 6.3 percent, the analysis of 16 countries showed that there were much lower annual real equity returns, where there US was among the top five countries. Although in general most countries did provide positive real returns on equities, the investment horizon was much longer that the estimated 20 years span, averaging 50-60 years. Thus, what can be concluded from such unambiguous answer?
First of all, the returns on equities in the long term are overestimated indeed. A definition of “long term” can be argued in that regard, where for the US such return turned positive starting from 20 years, while other countries required 50-60 years for the whole picture to turn “positive”. Accordingly, adjusting the historical findings to predict future return on equities, common stocks are less riskier than bonds, but still, “cannot be regarded as safe in real terms even when the investor has a horizon of 20 years or more” (Dimson, et al., 2004; Siegel, 2008, p. 36).
It can be concluded that investing in stock is a risky business, and the promoted rewards are still overestimated if compared to the risks involved and the required time span. Counting on the fact that holding equity for a long period is a guarantee of great rewards is groundless, specifically if such guarantee is based only on unique historical cases in the past.
References
Dimson, E., Marsh, P., & Staunton, M. (2004). Irrational Optimism. Financial Analysts Journal, 60(1), 15-25.
Siegel, J. J. (2008). Stocks for the long run : the definitive guide to financial market returns and long-term investment strategies (4th ed.). New York: McGraw-Hill.