The key measure to look at is something called the equity risk premium – the extra return you would have made by investing in equities over other asset classes such as bonds. London Business school professors suggest that the real equity return was positive "in every location, typically at a level of 3 per cent to 6 per cent. Equities were the best-performing asset class everywhere. Furthermore, bonds beat bills everywhere except Germany. This overall pattern of equities beating bonds, and of bonds outperforming bills, is precisely as we would expect, since equities are riskier than bonds, while bonds are riskier than cash". In aggregate, global terms, professors Dimson and Marsh suggest that an ongoing equity risk premium of between 3 per cent and 3.5 per cent a year for equities over bonds is about right, although they’re quick to point out that these estimates are at the lower end of historical returns. Still, even at these levels, they suggest that equity investing makes sense: "Equity investors can expect to be more than 40 per cent richer relative to investing in cash over a 10-year horizon, and twice as rich over 20 years."
Professors Dimson and Marsh also remind investors not to get too carried away with gloomy decades of apparent equity underperformance, as equities can also produce some quite staggering returns. Their version of a world equity index "rose by appreciably more during the 1980s (255 per cent in real terms) and the two post-world war recovery periods – by 206 per cent in the decade after World War I and 516 per cent from 1949 to 1959. During the latter period, several countries enjoyed staggering returns. For example, in the nascent years of the German and Japanese 'economic miracles', real equity returns were 4,094 per cent (ie, 40.4 per cent a year) and 1,565 per cent (29.1 per cent a year), respectively."
Overall, the data suggests that equities are worth the risk, maintains professor Marsh. "They are more rewarding in an expectational sense," he says. "In other words, you are going to expect to get a higher return from equities... but the reason you're going to get that is because of risk. There's a risk premium. Equities are priced at a discount and because of that you expect a higher reward from equities. But that higher reward is not guaranteed and so the notion that equities are for the long run is fine in so far as it goes, but there is no period over which you are safe. Equities are not a safe investment. By definition, they wouldn't give a higher reward unless they were risky."
Dividends matter
There's a major caveat to the LBS study – these equity returns are hugely impacted by the payment of dividends and investors' subsequent methodical reinvestment of those dividends back into the underlying ordinary shares. "A policy of investing $1 in US stocks at the start of 1900, and reinvesting all dividend income – 109 years later, the initial investment would have grown in purchasing power by 582 times, giving a total real return of 6 per cent per year", say professors Dimson and Marsh. By contrast, "a fund that paid out all of its income to beneficiaries rather than reinvesting dividends [paid out] just six times its initial value, equivalent to a real capital gain of 1.7 per cent per year. Thus a portfolio of US equities, with dividends reinvested, would have grown to almost 100 times the value it would have attained if the investor had spent or squandered the dividends. The longer the investment horizon, the more important is the dividend income. For the serious long-term investor, the value of a portfolio corresponds closely to the present value of dividends."
Put another way, a portfolio of US equities with dividends would have grown 97 times the value it would have attained if dividends had been spent.
So dividends matter, and the consistent reinvestment of dividends matters hugely. The only 'slight' problem is that most investors don't actually reinvest their dividends – the take up of dividend reinvestment programmes offered by large FTSE 250 companies is patchy at best. Anecdotal evidence from discussions with major mass market stockbrokers suggests that in reality only a (sizeable) minority of investors reinvest their dividends back into their core portfolio holdings with most investors trading in and out too quickly to set up any reinvestment plan.
Costs also matter
There's another equally important set of numbers that suggests equities aren't an easy route to riches – the data on costs. The work of professors Dimson and Marsh and other equity enthusiasts do allow for some trading costs, but they do not allow for the costs charged to most private investors by major fund management houses – bear in mind that the average actively-managed, wrap distributed unit trust in the UK charges close to 1.65 per cent a year whereas the average equivalent ETF (used extensively by institutions) costs closer to 0.5 per cent a year. There's already a huge weight of data that suggests that actively-managed managers favoured by most investors using independent financial advisers (IFAs) do not on average beat their index-tracking competitors and yet charge more for their underperformance.
But John Bogle, a legendary American analyst and founder of index tracking firm Vanguard, has taken the theme of costs and woven it back into an analysis of money-weighted returns – in particular he has looked at ETFs, which are by far the cheapest form of funds available to mass market investors in the UK.
Mr Bogle looked at the returns of 79 ETFs "in a variety of major asset categories over the past five years compared with the returns of the average dollar [actually] invested in those ETFs over the same time period". Even with ETFs – which tend to be used by more sophisticated, cost conscious investors – the results showed that out of 79 ETFs, 68 had investor returns that were short of the returns earned by the funds themselves. And by no small margin. The degree of investor-lag ranged from minus 0.4 per cent a year for large-cap value funds to minus 17.9 per year a year for financials ETFs. Investors did worst in high-profile and volatile sectors such as emerging markets, financials and real estate investment trusts (Reits).
On a simple average basis, ETFs in the study delivered a 1 per cent compounding return over the trailing five years, translating into a cumulative gain of 6 per cent. Investors, however, earned a minus 3.5 per cent average compounding return, translating into a cumulative loss of 12 per cent.
"When you combine those, you're talking about 18 per cent of investor capital that's been lost by all this trading," says Mr Bogle.
Think about Mr Bogle's conclusions for one minute. He has looked at a group of investors who use very cheap financial instruments in an intelligent way. Even this group of investors still fall for all the same momentum-seeking vices that everyone else seems to be guilty of. Most British investors don't use ETFs. They certainly don't have access to Vanguard's even cheaper index-tracking funds and are constantly barraged by advertising campaigns suggesting that they invest in the latest new faddish sector. Think about how few of us actually then stick with these funds through thick and thin over 10 or even 20 years, constantly reinvesting the resulting dividends. I suggest that even given the analysis of professors Dimson and Marsh there is a substantial equity premium – but it will vanish once our over-trading, our love of momentum, our willingness to over pay for supposedly expert advice and our failure to reinvest dividends, are taken into account.
Investor behaviour also matters
But perhaps the biggest hole in the arguments of those defending the Cult of Equities is something called money adjusted returns. It's a rather arcane term widely used by the industry to analyse not the ideal returns of a benchmark index (as used by the LBS study), but the actual returns based on flows of money from investors into funds.
The key issue here is that in reality investors don't treat investing in the way award-winning economist Paul Samuelson suggested they should: "Investing should be more like watching paint dry or watching grass grow." Private investors are heavily influenced by all sorts of momentum-based biases, flooding sectors with money that appear to be doing well recently, then selling when returns turn sour. This emotional behaviour destroys those putative long-term returns from equities.
The best analysis of this behaviour comes from the late 1990s when Morningstar Mutual Funds analysis in the US looked at time-weighted returns in mutual funds over the six years from the end of 1988 through the end of 1994. According to one report of this study, the Morningstar analysts concluded that "the average dollar invested in 199 growth funds experienced only a small fraction of the growth implied in the official time-weighted returns of those funds. The reason: real investors did not adopt a buy-and-hold strategy".
For the period from 31 December 1988 to 31 December 1994, the S&P 500 index produced an average time-weighted return of 12.22 per cent. But the dollar-weighted return of those funds in that period was only 2.02 per cent. Private investors destroyed the equity risk premium and their advisors did nothing to stop them.
Lukas Schneider of Dimensional Fund Advisers has updated this seminal analysis and looked at UK returns for 266 funds in a main equity sector. His research shows that from 1992-2003, the annual return of the FTSE All-Share was 8.99 per cent, while the average fund returned 6.93 per cent (with the difference accounted for by fund management costs). According to Schneider, the average fund investor received only 4.91 per cent over the same period. Evolve Financial Planning's head of investment James Norton put this into a simple context: "If an individual invested £100,000 at the start of the period, the actual return of the index would have resulted in a sum of approximately £281,000 compared with only £178,000 from the money-weighted average of the funds examined."
