One point about fund managers consistently underperforming the index, is that they all do essentially the same thing. To expect different results, one must be prepared to undertake a different approach to the problem such as investing in a smaller number of stocks in search of alpha instead of Beta.
That being said, here is an interesting article that makes your point about long term returns more clearly than I could...
Stocks for the Long Run?
By Steven Evanson, Evanson Asset Management
"Stocks for the long run."
This belief is pretty much investment gospel as of June 2001. Simply invest in stocks, and let the market bail you out over the long run. And, in the world of passive and index investing, a buy-and-hold attitude is quintessential. Dr. Jeremy Siegel, a professor of finance at Wharton, and author of the popular book, Stocks for the Long Run (1998), supports this view with a thorough analysis of stock market data, showing that stocks returned about 7% above inflation for the past two hundred years. Also, for twenty-year time frames, stocks outperformed bonds over 90% of the time.
However, extended long-term statistics can often conceal problems which may arise for investors with portfolios heavily allocated to stocks. So let's briefly examine historical data and argue for caution rather than uncritically accepting the hypothesis that stocks are always the best investment for the long-run.
1. The long run can turn out to be extraordinarily long, far longer than an investor's investment horizon.
If an investor entered the market during the last century when the Dow was one standard deviation above its long-term trend line - an exuberant bull market top - how long did they have to wait? For an investor who got in at the top in 1929, it took until roughly 1960, in inflation adjusted returns, to merely break even on his investment. At the next big bull top in 1968, it took until the early 1990s to break even - or about 25 years. Also, these are simply break-evens after inflation, a 0% return. These figures do not include dividends (data from Siegel, p. 59). Leuthold (InvestmentNews, 5/21/2001) notes that an investor at the peak in 1929 took until August 1998 - almost 69 years - to reach a nominal return of 10% on his money, including dividends. After inflation, this is a yearly return of about 7%. It took investors 69 years to reach the long-term expected return from stocks.
In addition, from its peak in 1929, our long-term investor had to endure an 86% decline in the value of his portfolio to its low in July 1932. The Dow Industrials holds some of America's largest and financially soundest companies, and cannot be considered an aggressive or speculative part of the stock market. Yet, investors choosing this relatively conservative sector would have required extraordinary nerves, and several decades to achieve average long-term stock returns on their investment, far more than can be realistically expected.
2. Real returns differ substantially depending upon time of market entry.
For the typical investor with a twenty or twenty-five year time frame, this can make for large differences in monies available for or during retirement. Frequently-presented "mountain" charts smooth out and conceal what happens to unfortunate investors who enter the market at or near long-term peaks.
An investor in the S&P 500 from 1929 through 1949 received an inflation-adjusted return of 4.54%. Yet, an investor beginning in 1932, and holding until 1951, received an inflation-adjusted annual return of 10.84%, over 6% greater per year. Our 1929 investor received a compound total return of 84.36% for twenty years; our 1932 investor received a compound total return of 818.13% for twenty years, and ended up with almost ten times as much as our unfortunate 1929 investor. Extend the holding period out to twenty-five years, and our 1929 investor does better, receiving a compound total return of 319.33%, but our lucky investor still receives far more, 2,202%.
Let's compare returns for the last big market top and bottom. An investor in 1968, a market top, had to wait until 1983, fourteen years, to just break even after inflation. If he waited until 1987, twenty years, his annual return was 4.19% after inflation, and his compound total return was 489.24%. If he waited until 1992, twenty-five years, his annual return was 5.83%, compounded to 1,132%. Today's big bull market began in the early 1980s, so only twenty years of data is available at this point. However, an investor in the market from 1981 through 2000 received a whopping after inflation return of 12.91% annually, and a compound total return of 1,741%. It was the best twenty years in U.S. market history. Yet, an investor in Japan at its peak in 1989 has experienced a 65% decline in the value of his holdings as of 2001, twelve years later.
It's very clear from the above numbers that luck or chance in the form of time of market entry plays a major role in the returns most investors can expect to receive. Enter at or near a market bottom and you may receive 6% to 8% or more per year than the investor who enters at or near a market top, and your compound returns may be up to ten times greater than those of an investor who enters at a market top. These are huge differences. Enter at a market top, and you may have to live through a 65% or greater decline, and receive only a break-even return for more than a decade. And, to make matters worse, there is no evidence that anyone can accurately time big market tops or bottoms.
3. Although extensive research indicates that the stock market cannot be accurately timed (Sherden, The Fortune Sellers, 1998), there is persuasive evidence that high stock valuations based upon traditional measures of value eventually leads to low future returns.
Robert Shiller (Irrational Exuberance, 2000) looked at twenty-year returns following market peaks in price/earnings ratios, and found inflation adjusted annual returns averaged -0.2% to +1.9%. Smithers and Wright (Valuing Wall Street, 2000) looked at historical data on the Q-ratio, similar to market-to-book value, and found that bull market peaks in Q have produced later declines in prices from 50% to 80%. As of 2001, most market valuations are higher than they've ever been, except for the last few years. Fama and French (The Equity Premium, working paper, July 2000), and Asness (Bubble Logic, partial book draft, December, 2000), employed other valuation measures, and reached similar conclusions about future equity premiums and returns. As of 2001, most market valuations are higher than they've ever been, except for the last few years.
4. Shiller notes that the U.S. was the most economically successful nation in history from 1900 through 1999.
Recent U.S. returns data almost certainly exaggerate potential returns, and the United States in the twentieth century may have been the exception rather than the rule in terms of real returns for stocks. Jorion and Goetzmann (Journal of Finance, 54[3], 1999) studied inflation-adjusted stock market appreciation, excluding dividends, for 39 countries for the period of 1926-1999, and found that the median real appreciation rate was only 0.8% per year compared to 4.3% per year for the U.S. Favorable social, economic, technological, and military conditions that led to these high U.S. returns may not repeat themselves in the future.
What can an investor conclude from the studies presented above? Do not accept the "Stocks for the Long Run" hypothesis as gospel. It is based upon the examination of very long-term returns data, and may not reflect what a real investor could experience in the market over reasonable investment time frames in the future. It most certainly underemphasizes the pain and disappointing returns stock investors may suffer. Wall Street and the money management industry have a vested interest in moving investors into stocks because they are compensated more for buying and managing stock portfolios than for bond portfolios. Wise investors should look at both sides of the risk/return picture.
Investors must be also be very careful about assuming past long-term returns will repeat within twenty or twenty-five year periods, particularly if they are dealing with lump sum or retirement monies. If that's the case, increasing allocations to bonds is one way of controlling the downside risk. Older investors in markets with high valuations may not live long enough to enjoy the benefits of stock investing, or may even outlive their principal if a serious bear occurs. Younger investors who contribute yearly have an opportunity to buy when markets are down. They also possess more time, which makes it likely - but not certain - that they will outlast bad bear markets.
Lump sum and retirement investors should also be cautious when using programs that purport to calculate how much money they will accumulate for retirement, and how much can be withdrawn safely each year during retirement. These programs are nearly meaningless if they use linear compounding calculations, the most common approach, and are a bit better if they use Monte Carlo probability estimates. But even Monte Carlo simulations depend upon past data and certain assumptions programmed into the calculations.
In sum, prudent investors should look closely at risk and return data, worst returns data hidden in long-term statistics, and only then critically evaluate whether the widely accepted belief that stocks are always the best long-term investment fits their particular circumstances and temperament.
06/05/2001
Steven Evanson, Ph.D. runs Evanson Asset Management in Monterey, CA. Dr. Evanson has a research background and has been in the financial services business since 1988. Evanson Asset Management specializes in passive portfolio management employing diversified asset class index funds.
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