Citation
Robinson, B. (2003), "Why investing in the year 2003 may be different", Balance Sheet, Vol. 11 No. 1. https://doi.org/10.1108/bs.2003.26511aab.001
Publisher
:Emerald Group Publishing Limited
Copyright © 2003, MCB UP Limited
Why investing in the year 2003 may be different
Bill RobinsonBill Robinson is Head UK Business Economist in Financial Advisory Services at PricewaterhouseCoopers. He is a former Special Adviser to the Chancellor of the Exchequer.
What returns can investors expect if they go back into the market? Are prospective future returns different from past returns? Are equities a better bet than bonds?
To answer these question it is helpful to begin with the splendid scholarly analysis of investment returns, based on 101 years of data, by the London Business School professors Elroy Dimson and Paul Marsh[1]. An analysis of returns over different holding periods, summarized below, reveals that equity returns have been close to 6 percent in real terms compared with only 1 percent on bonds. For much of the past century unanticipated inflation robbed bond holders, while equity holders were protected from it (because share values and dividends rose at least in line with inflation).
Volatility versus long-term growth
Most people know that equities outperform bonds in the longer term. But not everybody understands the importance of being a long-term holder of equities. In the short term share values are extraordinarily volatile. Over the past hundred years there was one year when you doubled your money and another when you lost half of it. In 25 of those years you would have lost more than 4.6 percent and in another 25 you would have made more than 17.5 percent. For a one-year holder, equities are a seriously risky investment. But if you hold for 25 years the returns will (with a 50 percent probability) lie in a much narrower range, between 4.6 percent and 7.1 percent. As the Tables show, the inter-quartile range of investment outturns narrows sharply as the holding period increases.
| Holding period(years) | Mean1(%) | Std dev.(%) | Inter-quartile range | ||
| First (%) | Median (%) | Third (%) | |||
| 1 | 7.4 | 20.3 | –4.6 | 5.9 | 17.5 |
| 4 | 6.3 | 9.1 | 1.4 | 5.8 | 12.4 |
| 5 | 6.2 | 8.1 | 1.6 | 6.9 | 12.8 |
| 10 | 6.0 | 5.4 | 1.9 | 5.9 | 10.7 |
| 15 | 5.9 | 4.4 | 2.5 | 5.7 | 9.5 |
| 20 | 5.9 | 3.2 | 3.5 | 5.2 | 8.1 |
| 25 | 5.9 | 2.1 | 4.6 | 6.0 | 7.1 |
Note: 1Arithmetic mean of moving averagesSource: DMS data/PwC Analysis
Table I UK equities (1900-2001)
| Holding period(years) | Mean1(%) | Std dev.(%) | Inter-quartile range | ||
| First (%) | Median (%) | Third (%) | |||
| 1 | 2.2 | 14.7 | –5.4 | 0.7 | 7.3 |
| 4 | 1.6 | 8.1 | –2.9 | 1.6 | 6.5 |
| 5 | 1.6 | 7.4 | –2.7 | 1.0 | 6.5 |
| 10 | 1.2 | 5.7 | –3.0 | 0.5 | 6.3 |
| 15 | 1.0 | 4.8 | –2.5 | –0.6 | 5.3 |
| 20 | 1.0 | 3.8 | –2.1 | –0.6 | 4.7 |
| 25 | 1.0 | 2.9 | –1.3 | 0.3 | 2.8 |
Note: 1 Arithmetic mean of moving averagesSource: DMS data/PwC Analysis
Table II Government bonds (1900-2001)
A simplistic reading of the above Tables would suggest that the investor has a choice between equities yielding 6 percent real return and bonds yielding 1 percent. This 5 percent gap between equity and bond returns is the so-called equity market risk premium. It looks remarkably generous given that over a 25 year holding period, the variability of real bond returns (which reflects the variability of inflation) is actually greater than the variability of real equity returns. With a 5 percent premium on equities, and no additional risk for the patient investor, there is on the face of it little reason to choose bonds over equities.
The past is our best guide to the future, but there are important respects in which the future is likely to be different from the past. Perhaps the most important difference is in inflation prospects. A long bond today yields 4.6 percent. The Bank of England's inflation target is 2.5 percent. So conventional gilts today are offering a prospective real yield of over 2 percent. Moreover, the markets currently believe that inflation will be below target – index-linked gilts are offering a return of 2.25 percent. Bonds today offer a much better real return than past outturns would suggest.
Look to history
So what advice can an economist offer the investor in the light of this information? According to the standard theory, the prospective return on equity should be equal to the risk free rate of interest (4.5 percent nominal) plus the equity market risk premium. Historically, as we have seen, that premium was 5 percent, implying a 9.5 percent return on equities. But that historic premium probably reflects the exceptionally poor performance by bonds in the two inflationary periods after each world war. Dimson and Marsh's estimate of the equity risk premium for the UK is 2.4 percent, which is in the lower half of a wide range of economists' views that goes from below 1 percent to over 7 percent. A reasonable consensus view might be 4 percent, implying a rate of return on equities going forward of 8.5 percent.
Another way of estimating future nominal returns is to take past real returns, at 6 percent, and add a prospective inflation rate of 2.5 percent. This also gives a total of 8.5 percent.
Is this number realistic? Those who have held equities over the past three years, and seen the market fall by a half, may find them difficult to believe. But clearly the lower are share prices relative to current dividends and underlying earnings, the lower is the growth of profits expected by the market, and hence the more realistic the market valuation. At the end of 2002, with the FTSE 350 index trading around 1,900, the market is trading on a dividend yield of 3.5 percent. If profits grow in line with the economy, at a trend real rate of 2.5 percent, this implies a total real return of 6 percent. The implied nominal return is 8.5 percent.
A time of fair value
The conclusion from this analysis is that the market is fairly valued. It implicitly promises future returns of 8.5 percent, which is exactly in line with the historical experience. Those equity returns imply an equity risk premium of 4 percent compared with conventional gilts, which again is very much in line with the consensus. So is it now safe, after the three year correction, to go back into the market and buy equities? The answer is that the one-year returns on equities could, as always, be very good or very bad. But for someone intending to buy and hold for 25 years (e.g. in a pension scheme) there is no reason to believe that equities will not deliver long run returns as good as the average over the past century, outperforming gilts by 4 percent per annum.
Note
1. Triumph of the Optimists 101 Years of Global Investment Returns by Dimson, Marsh and Staunton, Princeton University Press