In their study 'Triumph of the Optimists (2000)', London Business School academics Elroy Dimson, Paul Marsh and Mike Staunton illustrated the astonishing success of global (and especially US) equities in the 20th century. Continuing this study annually, the team published its Global Investment Returns Yearbook (in association with Credit Suisse). While there are plenty of reasons to be cautious about future returns, the 2017 report suggests that shares should continue to offer investors a worthwhile premium.
The yearbook highlights the positive correlation between low real interest rates and returns on bonds and equities and the bad news is that, although yields on sovereign bills and bonds have risen from their 2016 low, returns look likely remain subdued. This will disappoint investors who are anticipating a return to 'normal' interest rates. But are expectations set too high?
Data from the study, going back to 1900, shows that real interest rates seen around the world between 1981 and 2008 were exceptional. Although investors have become conditioned to expect the correspondingly high return on equity and bond investments that were enjoyed in this period, the reality is that we are more likely to see lower bond returns, closer to the long-run average.
Since 1900 the overall global equity premium over US short-term treasury bills has been 4.2 per cent, with an annualised real rate of return of 5.1 per cent. Going forward, on the back of falling real dividend growth, the academics expect the equity premium to fall to around 3 to 3.5 per cent. This means that, given low bond yields, investors are going to have to take higher risks to make lower real returns.
This presents portfolio managers with a conundrum - how much risk should they add? Some of the other research in the yearbook should caution against abandoning principles of sensible asset diversification. The real peak-to-trough drawdowns suffered by portfolios split between equities and bonds since 1900 would have been far less severe than those experienced by a portfolio 100 per cent in US equities.
On a positive note, although there are diminishing real returns from equities, the higher inflation gets (shares can't really be described as a 'hedge' against inflation), shares remain a good investment for those with a long time horizon in which to grow their wealth in real terms - in other words, the equity risk premium remains worthwhile.
