- Fees and dividends have a much bigger impact on investor returns over the long-term than the short-term
- Future technological change is a factor which should only play on the minds of long-term investors
The Brothers Grimm told a fairy tale, Hans In Luck, in which the protagonist starts with a big lump of gold and makes a sequence of trades each one of which seems reasonable, only to end up with nothing. This story applies to investors, because we too can lose money in the long run because of decisions that seem sensible in the short.
One example of this is trading itself. Any individual trade seems reasonable, like Hans trading his gold for a horse. But taken altogether trading costs us money. As Brad Barber and Terrance Odean concluded in a classic paper, investors “pay a tremendous performance penalty for active trading”.
Another example are fund managers’ charges. An extra half per cent of annual fees seems innocuous. Which it is if you hold the fund for only a few months. In the long run, however, things are different. That extra half per cent over 20 years could easily cost you £2,000 for every £10,000 you invest. What looks reasonable in the short run is not so in the long run.
Yet another example is the role of dividends. If you hold a share for only a few months dividends are often swamped by capital gains or losses. For a six-month holding period even a relatively stable share has around a one-in-three chance of delivering a return four times as great as its dividend and an almost the same chance of losing four times its dividend.
In the long run, though, dividends are crucial. My chart shows how. Each point on the line shows the annualised return you’d have made on the All-Share index since the date on the horizontal axis. So, had you bought in December 2003 you’d have made 3.2 per cent a year before inflation from capital gains but 7 per cent from these gains plus reinvested dividends. For many periods, dividends represent more than half, and sometimes more than two-thirds, of total returns – and indeed often more than all of inflation-adjusted returns. And this gap compounds over time. If you’d put £100 in the All-Share index in January 2000 and spent the dividends you would now have £129. But if you’d reinvested them, you’d have £265.
This does not mean you should buy high-yielding shares: that’s another story. But it does mean that long-term investors should expect most of their returns to come from dividends. If you spend your dividends, you should brace yourself for low returns – perhaps even negative ones after inflation.
These aren’t the only ways in which the long term is very different from the short.
From day-to-day or even year-to-year around half of all shares will beat the market – and maybe more if the market is dragged down by one or two huge stocks doing badly, as happened last year. In the longer run, however, things are very different. As Hendrik Bessembinder at the Arizona State University has shown, most shares over their lifetimes not only underperform the market but even underperform cash. Maynard Keynes famously said that “in the long run we are all dead”. He might have added that, in the long run, so too are most companies.
This means that long-term stockpicking is a completely different job from short-term stockpicking. Not only do you face much worse odds, but you must answer questions which the short-term stockpicker can ignore such as: will future technical change or competition destroy this firm? Or will future management make some bad decisions? The answers to such questions are, I fear, often genuinely unknowable: the fact that Nokia’s price is now 90 per cent below its 2000 peak tells us that few investors foresaw that it would be ruined by the invention of the smartphone.
We don’t appreciate Bessembinder’s finding sufficiently because we underestimate the power of slow-moving forces. From month-to-month we don’t really see just how strong are the forces of market competition and creative destruction. Over time, however, these select against most companies with the result that a tiny fraction of them account for all of the long-term rise in stock markets.
These are not the only long-term forces that we under-rate in our focus upon the short term. From month-to-month, let alone day-to-day, moves in bond yields have seemed inconsequential. Viewed over 25 years, however, they have been extraordinary: real gilt yields have fallen from almost 4 per cent to minus 2 per cent since the mid-1990s. And this is a symptom of huge changes in the world economy such as a shortage of safe assets; falling returns on real assets; a dearth of investment opportunities and other factors that have combined to produce secular stagnation. Our focus on the short term causes us to neglect such revolutionary developments.
In the short term we see the weather, but in the long term it is the climate that matters, and these are not the same. The long term is not just a stretched-out version of the short term, but is in fact a very different thing. If you are to be a genuine long-term investor, therefore, you need a very different mindset than a short-term one.