Does the stockmarket still reward investors?
A client recently asked a great question: given that in recent years many investors haven’t been rewarded for taking risk in the stockmarket, do we think that this may continue?
When we invest our money in the stockmarket, we expect to get a higher return compared to investing in cash or bonds because we’re taking more risk and deserve to be rewarded – this is effectively the foundation of capitalism. In technical terms, we call the difference between the return on cash and the return on shares the Equity Risk Premium (ERP).
It’s also based on a simple, accepted principle – that risk and return are related.
Over the longer term, there is clear evidence that stocks provide higher returns than cash. However, there can be periods of time – quite long periods of time in fact – where this principle doesn’t hold true.
If we look at returns in the U.S during the period 2000 to 2009, 10 year Treasury bonds (which are effectively considered to be a risk free asset) outperformed the U.S stockmarket by 8.6% pa. That was quite a remarkable outcome, especially when you consider that over the 75 years leading up to 2000, U.S stocks had outperformed Treasury bonds by an average of 6.2% pa.
Several leading financial academics estimate that the average long term ERP is between 3.5% and 4.5% per annum . The compound effect of this higher return over time can be profound.
The absence of any reward for taking equity risk in the first decade of the century – due to the impact of the GFC – led some naïve commentators to suggest that we could no longer expect to receive a higher return for investing in the stockmarket. Some contend there is a ‘new normal’ and the future won’t be as bright as the past.
We disagree. There are a few key points investors need to remember.
First, one of the words in ‘equity risk premium’ is risk. So it’s never a sure thing. Investors didn’t get a positive return in the 1930s either, but you get the premium in most decades. Looking back, around 7 out of 10 years provides a positive return from investing in the stockmarket.
Second, the equity risk premium is really a function of how investors perceive the risk of being invested in stocks instead of cash. So the size of the premium is never static. When markets are volatile – as they have been recently – the ERP actually goes up to compensate investors for the higher perceived risk, whilst in strong bull markets the ERP actually falls.
Investors always become more risk adverse during recessions, when company earnings fall and unemployment rises. This is simple human nature. Given that we’ve just been through the second biggest global recession in memory, it’s understandable that some investors remain pensive about being invested in the stockmarket.
However, when stock prices fall, the possibility of higher company earnings when the economy recovers means that there is a higher expected return from holdings stocks. In fact, the expected return from stocks is actually lower when the economy is growing strongly, because this can be a forerunner to higher inflation, which translates into higher interest rates and slowing economic growth.
It’s an interesting conundrum that is illustrated in the following graph:
What has occurred in global stockmarkets over the past few months is a great reminder of this principle.
Although the U.S and European economies are not yet in full health, they are recovering – the European Central Bank has even declared that the worst of the Eurozone crisis is over . The market is now anticipating higher company earnings in coming years, which has resulted in 2012 delivering the best start for global stockmarkets since 1991. Investors who have been too focused on what’s happening in Europe and particularly Greece today and tried to shelter their funds in cash and bonds have missed out.
We have implemented strategies for various clients such as including strategies like minimum cash buffers equivalent to five years of annual cashflow needs in client portfolios to reduce the risk of events like Greece forcing them – particularly retirees – to sell stocks at distressed prices when markets are down. This helps to keep investors disciplined and maintain their exposure to stockmarkets even when human emotions cause them to want to sell out.
Finally, we need to remember that people are capable of great innovation. Every year, new ideas and industries are born, often rendering longstanding industries or companies obsolete. This is a reminder of the importance of diversification (remember the recent failure of Kodak).
For instance, we recently came across one new innovation that could have significant and immeasurable impact on manufacturing right around the world. It’s called a 3D photocopier, and we recommend you watch the following video on how it works:
In summary, we are absolutely confident that investors will continue to be rewarded for taking or capturing risk over the mid to longer term.
Author: Rick Walker
Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.