The Journey of Owning Shares

In an ideal world, none of us would have to invest in shares.  Instead, we could all put our portfolio into low risk government bonds and live off the income.

However, in reality, almost all investors need to take some investment risk to build their wealth over time.  And the good news is that if you have or can afford to have (through good strategy) a longer time horizon for your investments, the journey of owning shares should still allow you to sleep at night – so long as you don’t expect positive investment outcomes every year.

Let’s start by looking at how often investing in the stockmarket delivers a higher return than investing in cash or low risk bonds.  The graph below looks at 1, 5, 10 and 15 year timeframes for Australia, the U.S, Developed Markets excluding the U.S and Emerging Markets using all of the actual data available to us.

Market vs Cash [1]

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The evidence shows that when you invest in the stockmarket, you can reasonably expect to earn a higher return than cash for 2 out of every 3 years.  This highlights the short term risk of investing in equities.  However, as you would expect, as the time horizon increases, the probability of your share portfolio outperforming cash increases as well. 

It is important to note though that in every market observed, even over 15 year time periods, there have been times when shares underperformed cash. Whilst it is a rare outcome, it does happen. 

As an example, over the past 40 years in Australia, if you invested in shares in five months during 1995 or mid 2002, 15 years later your share portfolio was worth less than a low risk bond portfolio.  However, in every case, the results were marginal with cash only just outperforming stocks over the 15 year period.  So if you can afford to invest for a long period of time, it may make sense to invest in equities rather than cash.

But you always need to remember that sharemarkets are inherently volatile.

We have data for the US S&P500 Index going back to 1926.  This index tracks the performance of the 500 largest public companies in America.  Over these 92 calendar years, the S&P500 returned an average of 10.2% pa, which as an average is fantastic. However, investors shouldn’t expect the average to be meaningful in terms of their expected return each year.

Over the 92 annual periods, on only 6 occasions was the annual return within 2% of the average, i.e. the actual return was between 8.2% and 12.2%.

But on how many occasions was the annual return either -20% or less or +20% or more?  The answer is 40 times – that’s 40 times out of 92.  So volatility is real and should be expected when investing in equities.

If we determine it is appropriate for a client to have some exposure to equities, we need to set up their portfolio to target factors that financial science has shown deliver higher expected returns.  Two key factors we target are the Value premium and Small Company premium.

We use the price to book ratio to categorise a stock as either a Value (i.e. cheap) or Growth (i.e. more expensive) stock.  We know that over time Value stocks offer higher returns than Growth stocks, but how often does this occur?  The graph below shows the historical answer.

Value vs Growth [2]

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We can observe that over 12 month periods, investors are generally rewarded with a Value premium 50% to 70% of the time.  But increase the time horizon to 10 to 15 years, and the Value premium is much more frequent.  In fact, over 15 year periods there has always been a Value premium in Australia, Developed Markets excluding the U.S and Emerging Markets.  In the U.S, the times when a Value premium wasn’t evident over 15 year periods were if you invested in 1926 (Great Depression impact), 1984 (’87 Crash + Tech Bubble Crash) and 2001 (GFC, 2001 recession and oil price surge of 2011).  But for patient investors, the Value premium can add incredible upside to their portfolio over time.

We also know that smaller stocks offer higher expected returns than large company stocks because they’re riskier assets to own.  The graph below shows how frequently small stocks have outperformed large stocks:

Small vs Large [3]

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As you can see, the Small Company premium isn’t as prevalent as the Value premium, however it does exist most of the time.  That is why we still target this factor when constructing portfolios, albeit to a lesser extent than the Value premium.

The table below shows the average annual Value and Small Company premium over the available time period of actual data:

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These market premiums are statistically proven to exist through financial science, so it is neglectful of any investor to not specifically target these factors in their portfolio.  This becomes especially true when you look at the evidence of how most active managers (e.g. stock pickers and market timers) perform.

The following table shows what percentage of active Australian fund managers beat the index over the past 15 years for different time periods[4]:

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The results clearly point to the failure of the active fund management industry to add value for investors sufficient to justify their relatively high fees. 

We will never claim that the evidence based investment strategies we build for clients at Stewart Partners will outperform the market – or your friends – every day, month or year, but no investment approach can achieve this. 

However, our investment approach gives you the greatest probability of outperforming investment markets over time whilst still enabling you to sleep at night – and when it comes to investing, the journey is as important as the destination.  The value of living a life with minimal or no money worries may be difficult to quantify, but if you’ve known the alternative, you know how important it is.

We put financial science to work for our clients who invest in equities by adding value through identifying relevant dimensions of expected return and continually balancing the trade off amongst competing premiums, diversification and costs based on the needs and goals of the individual.  It is why we exist – to help replace money worries with financial peace of mind.

 

Please note that past performance is no guarantee of future performance.

[1] AUS - Australian Market vs. Bank Bills: Market is MSCI Australia Index (gross div., AUD). Bank Bills is Bloomberg AusBond Bank Bill Index. There are 301 overlapping 15-year periods, 361 overlapping 10-year periods, 421 overlapping 5-year periods and 469 overlapping 1-year periods. US - Market is Fama/French Total US Market Index. T-Bills is One-Month US Treasury Bills. There are 907 overlapping 15-year periods, 967 overlapping 10-year periods, 1,027 overlapping 5-year periods and 1,075 overlapping 1-year periods. Developed ex-US - Market is MSCI World ex USA Index (gross div.).  T-Bills is One-Month US Treasury Bills.  There are 385 overlapping 15-year periods, 445 overlapping 10-year periods, 505 overlapping 5-year periods and 553 overlapping 1-year periods. Emerging Markets - Market is MSCI Emerging Markets Index (gross div.). T-Bills is One-Month US Treasury Bills.  There are 157 overlapping 15-year periods, 217 overlapping 10-year periods, 277 overlapping 5-year periods and 325 overlapping 1-year periods.

[2] AUS - Australian Value vs. Growth: Value is Fama/French Australian Value Index. Growth is Fama/French Australian Growth Index. There are 325 overlapping 15-year periods, 385 overlapping 10-year periods, 445 overlapping 5-year periods and 493 overlapping 1-year periods. US - Value is Fama/French US Value Index. Growth is Fama/French US Growth Index. There are 907 overlapping 15-year periods, 967 overlapping 10-year periods, 1,027 overlapping 5-year periods and 1,075 overlapping 1-year periods. Developed ex-US - Value is Fama/French International Value Index. Growth is Fama/French International Growth Index. There are 325 overlapping 15-year periods, 385 overlapping 10-year periods, 445 overlapping 5-year periods and 493 overlapping 1-year periods. Emerging Markets - Value is Fama/French Emerging Markets Value Index. Growth is Fama/French Emerging Markets Growth Index. There are 157 overlapping 15-year periods, 217 overlapping 10-year periods, 277 overlapping 5-year periods and 325 overlapping 1-year periods.

[3] AUS - Australian Small vs. Large: Small is Dimensional Australia Small Index. Large is MSCI Australia Index (gross div., AUD). There are 337 overlapping 15-year periods, 397 overlapping 10-year periods, 457 overlapping 5-year periods and 505 overlapping 1-year periods.  US - Small is Dimensional US Small Cap Index. Large is S&P 500 Index. There are 877 overlapping 15-year periods, 937 overlapping 10-year periods, 997 overlapping 5-year periods and 1,045 overlapping 1-year periods. Developed ex-US - Small is Dimensional International Small Cap Index. Large is MSCI World ex USA Index (gross div.). There are 385 overlapping 15-year periods, 445 overlapping 10-year periods, 505 overlapping 5-year periods and 553 overlapping 1-year periods. Emerging Markets - Small is Dimensional Emerging Markets Small Cap Index. Large is MSCI Emerging Markets Index (gross div.). There are 157 overlapping 15-year periods, 217 overlapping 10-year periods, 277 overlapping 5-year periods and 325 overlapping 1-year periods.

[4] Source: SPIVA Australian Scorecard for 31 December 2017.

Rick Walker