Critics of the Cult of Equity accept that over the very long term equities do outperform, that fact ignores the stark reality of most private investors' life spans and 'window of opportunity'. In simple terms, we don't invest for 50 years. Even defenders of equities such Elroy Dimson, Professor of Finance at London Business School, accepts that the very best kind of investor in equities is probably a university endowment that can afford to take a 50- to 100-year time frame.
Most individuals tend to have a 20 to 30 year window of opportunity to invest. Very few of us can afford to invest much in our 20s, so for most investors the sensible window of higher-risk investing opportunity is likely to be 30 years at most. And the sad reality is that for the past 40 years bonds have been better investments than equities, according to Mr Arnott and Mr Mauldin.
Another US analyst, Ed Easterling (check out his number crunching for free at www.crestmontresearch.com), doesn't deny that over the long term equities are a great investment. He accepts that by looking at genuinely long series of data for the S&P 500 (there's no equivalent long data for the FTSE 100 or All-Share), we can sensibly assert that the overall average annual return of the S&P 500 for the past 100-plus years is around 7 per cent a year. But Mr Easterling then breaks down these returns into discrete bear and bull market cycles, and what becomes obvious is that there are long periods in which the market suffers some terrible losses, although there are some equally impressive periods when the market does very well. If you're lucky you'll manage to hit the bull cycles, if you're unlucky you'll hit the long bear cycles.
Mr Easterling's analysis suggests that for the American market 63 per cent of the total years under analysis reflect positive returns while 37 per cent are negative.
Using Mr Easterling's data, we can fairly safely state that although many periods generated positive returns (before dividends and transaction costs), half produced compounded returns of less than 4 per cent. Less than 10 per cent generated gains of more than 10 per cent. As Mr Mauldin notes: "The simple fact is that the stock market rarely gives you an average year. The wild ride makes for those emotional investment experiences which are a primary cause of investment pain."
Bear markets can go on and on
The historical records (again nearly always US data over 200 years) suggest that periods of low equity returns can be very long. Here's Mr Arnott again peering into the history books, this time looking first at the 19th century. "From 1803 to 1857 stocks floundered, giving the equity investor one-third of the wealth of the bond holder; by 1871, that shortfall was finally recovered," suggests Mr Arnott. "Most observers would be shocked to learn that there was ever a 68-year span with no excess return for stocks over bonds.
"Then again, between 1932 and 2000, we experienced another 68-year span in which stocks beat bonds reasonably relentlessly, and we were again persuaded that, for the long-term investor, stocks are the preferred low-risk investment."
The optimists
It's fair to say that the case made by these American critics is far from conclusive or proven – one particular criticism is that the renegades carefully mine their data, selecting entry points in terms of start years that prove their case. The definitive analysis of long-term markets data by contrast comes from a group of English academics at the London Business School (LBS). Led by professors Paul Marsh and Elroy Dimson, this team laid out their most definitive analysis in their 2002 book, The Triumph of the Optimists, which looked at stock market returns from 16 countries over the 101 years from 1900 to 2000.
The LBS academics are scrupulously fair in their analysis of long-term data, and professor Marsh in particular is quick to accept Mr Arnott's point that equities can be a bad investment over many long periods of time.
"The past decade has been absolutely terrible for equities," concedes professor Marsh. "In fact, in the US bonds have done just about as well as equities over the past 40 years."
But professor Dimson and professor Marsh are quick to counter this gloom with a more optimistic long-term assessment – their analysis of the data in The Triumph of the Optimists suggests a number of crucial conclusions:
■ Over the entire 101 years, nominal (real) compounded returns for US stocks, bonds and bills were 10.1 per cent (6.7 per cent, 4.8 per cent (1.6 per cent) and 4.1 per cent (0.9 per cent), respectively, assuming the reinvestment of all dividends and interest.
■ Returns on bonds were lower than returns on equities in all 16 countries. They also discovered that in five of 16 countries, real returns on bonds were negative over the entire 101 years.
■ In the US and the UK, reinvested dividends would account for nearly half of an investor's total annualised return from equities in the past century.
These main conclusions have since been updated in the team's newest publication, the annual Credit Suisse Global Investment Returns analysis, which now looks at a total of 17 countries over 109 years. In the most recent 2009 edition, they conclude: "An initial sum of $1 invested in US equities in 1900 grew, with dividends reinvested, at an annualised rate of 9.2 per cent per year to become $14,276 by the end of 2008. An initial investment of $1 would have grown in purchasing power by 582 times. The corresponding multiples for bonds and bills are 9.9 and 2.9 times the initial investment, respectively. These terminal real wealth figures correspond to annualised real returns of 6 per cent on equities, 2.1 per cent on bonds and 1 per cent on bills."
The next 10 years
The next decade might just surprise everyone with stellar equity returns. Professor Dimson for one is certainly optimistic: "When we look forward, I don't sit on the fence here. I think there is a case that could be made that the worst is behind us, because we've seen stock prices improve and they'd have to fall a quite measurable amount to get back to a position that took us down to three and a half thousand [for the FTSE 100]. But as for the future, I think if you've got some spare cash that you never had before, now's obviously a better time to invest than when the market was at one and a half or twice it's current level." And if Professor Dimson is right, then maybe we'll all be lucky, and maybe we'll all pile into the right sectors, and maybe all those costs of trading won't matter because rising share prices will make us forget what can go wrong...
How to succeed with your equity investments
■ Invest for the longest time frame possible. At least 50 years would be ideal. This might mean starting an investment habit in your 20s.
■ Think about whether you are in investing in an equities bull cycle or bear cycle. If it's the latter, the real returns on bonds will probably beat equities. Stockmarkets can perform badly for long periods of time.
■ Don't give up on equities following periods of under-performance. The data shows that equities can produce staggering returns and equity investors can expect to be more than 40 per cent richer relative to investing in cash over just 10 years.
■ Reinvest your dividends. This is crucial. One study shows that a portfolio of US equities with dividends would have grown 97 times the value it would have attained if the dividends had been spent.
■ Avoid emotional investing – pouring money into sectors that appear to be performing well, then selling when returns turn sour. Chasing after the best performers in this way is a disastrous strategy. Not only will you miss out on peak returns but your costs will be much higher.
