The scary long term

Conventional theory says that, for equity investors, the long-term is not so bad a place. This is because if returns in one period are independent of those the next, then losses in one period might lead to gains in another, making longer-term returns quite stable. In such a world, volatility rises with the square root of time. On reasonable assumptions (a 5 per cent average annual return with standard deviation of 15 percentage points), this implies that while there’s almost a 40 per cent chance of a loss over 12 months, there’s a less than 10 per cent chance of a loss over 10 years. This doesn’t mean that shares are safer over the long-run, because a loss over 10 years is nastier than one over 12 months. But it does mean the long-run isn’t very different from the short.

Sadly, however, this view is horribly incomplete. Whilst volatility might rise only slightly over time, uncertainty explodes. We can be reasonably confident that, over the next few months, well-run companies won’t be destroyed by bad management decisions or by competition. Over say, 20 years, however, we can have no such confidence at all. In the long-run, creative destruction hits even the best firms. In the 1980s, companies such as ICI and GEC were the core of any blue-chip portfolio. Where are they now?

This has another, under-appreciated implication. It means the distribution of equity returns over the long-run is very different from the short. In the short-run, it’s reasonable to assume that around half of stocks will beat the market – more than this if small stocks do well, less if big ones do well. In the long-run, however, things are very different. Hendrik Bessembinder at Arizona State University has shown that, over the course of their lifetimes, most stocks don’t just underperform the market – they even under-perform cash. He estimates that only 1 per cent of shares account for all the net wealth created by global stock markets since 1990. Over the long run, only a tiny minority of companies can survive what Joseph Schumpeter called the perennial gale of creative destruction.

If you underweight this 1 per cent you will underperform the market. This is why so many US fund managers have underperformed: the S&P has been driven up by a handful of stocks such as Apple and Amazon. Instead, genuine long-term investors should own tracker funds. These guarantee you exposure to the superstar stocks of the future.

Uncertainty, however, isn’t just a problem for stock-pickers. It matters for the whole market. In a classic paper Will Goetzmann and Philippe Jorion showed that many of the stock markets that existed in the early 20th century were subsequently closed by war or revolution. If you were a Russian investor in 1910 or a Japanese investor in the 1930s, equities were a decent short-term investment but a calamitous long-term one.

You might think there’s no danger of war and revolution now. Maybe not. But it doesn’t follow that all is well. In the US in particular the socio-political climate is been extraordinarily friendly for equities in recent years; the share of wages in national income (and labour’s power generally) has fallen and there has been little resistance to the rise of monopoly power. Whilst these conditions might remain in place for a while longer, we’ve no assurance they must remain for long.

This is especially true because of another fact. Profit rates in developed economies generally have been in long-term decline: yes, this is consistent with the declining wage share in the US. Which poses the question: if this trend is not reversed, what will capitalism look like in 20 or 30 years’ time? How can low and falling profit rates co-exist with a healthy stock market? Short-term investors can ignore this issue. Long-term investors cannot.

Which brings us to another difference between the short and long term. In the short run, international equity diversification is of little use, because national stock markets tend to all fall together in a crisis, as we saw in the spring. Over the long term, however, returns can differ enormously. In the past 10 years US stocks have tripled UK investors’ money while emerging markets and the All-Share index has given returns of less than 20 per cent. Of course, there’s no reason to suppose that the US will continue such stellar performance in the long-run. But the message here is that long-term investors must spread their holdings around the world to avoid being trapped into poorly-performing markets.

It is, however, not just equities where the long-term is very different from the short. The same is true of gold. Over shorter periods, gold is no protection from actual or expected inflation. The fact that it hit a record high this summer while inflation fell across developed economies tells us this. So too does the fact that, in recent years, gold has tended to fall when UK inflation expectations have risen.

In the long run, however, things are different. Claude Erb and Campbell Harvey have pointed out that the Emperor Augustus, who ruled Rome from 27BC to 14AD, paid his centurions 38 ounces of gold a year. That’s equivalent to just over £55,000 today. Which is only a little more than an experienced Army captain gets. Gold, then, has kept pace with wages for 2000 years.  In the long run, it has been a fantastic protection against rising prices and wages.

Sadly, though, not many of us have time horizons of 2000 years.

In fact, I’m not sure how many of us are long-term investors at all. Of course, many of you have held some stocks for a long time, and intend to continue doing so. And many of you – sensibly – try to trade very little. But this doesn’t make you a long-term investor. As long as you review your portfolio regularly and have the option of trading, your time horizon is only as long as the time to your next review. Just as Zsa Zsa Gabor was a serial monogamist, so many of us are serial short-term investors.

And so we should be. The future is a hugely uncertain place which could destroy the best companies and investment strategies. It’s much better and safer to stay in the short term.