Are shares a safe bet in the long term?

Time heals all wounds. As in life, as in investing. Or so the average financial adviser will tell you.

The standard argument goes as follows. If your investment horizon is long enough, any bad years in the share market will be ironed out by the upward trend over the long term. Stay the course, and you’ll be fine. Equities might underperform bonds or cash over the next few years. But over 5 years? 10 years? 30 years? Unlikely. So goes the story.

However, there is a fatal omission in this argument, which I outlined in my previous post concerning risk and investing. While your investment returns can compound nicely over the long term, so does the uncertainty surrounding these returns.

One of our readers, Brent (aka BB) has sent in two excellent charts (originally from Paul Resnik at Finametrica) that illustrate this point very well.

Many of you will have seen a variant of the chart below, which shows that the longer the time horizon of your investment (in this case using historical returns for the All Ordinaries), the less variability in your expected returns. The red lines represent one standard deviation above and below the mean. If  you don’t remember what standard deviation is, no problem. The chart is just illustrating that the longer the period of investment in the stock market, the more predictable your annualized return becomes. This concept is known as “time diversification”.

Similar charts are often used to argue that young savers (in their 20s and 30s, for example), should have a high proportion of their investment portfolios in growth assets like equities. While equities are more volatile than bonds, they have historically offered greater return potential. This volatility can be smoothed out by investing over the long term, reducing risk.

However, while this chart may look very convincing on the surface, it is actually presenting a very misleading picture. Why? What matters to an investor is not the annualized return, but the total return on the investment at the end of the period. And the longer the period of investment, the greater the uncertainty surrounding this total return:

As Brent says:

The range of potential outcomes increases over time, not decreases, as small variations in percentage returns generate large variation in end dollar values. Granted, the magnitude of absolute negative returns is decreased (based on All Ords performane between 1972 and 2009) but perhaps this is the message that should be taken from long-term return assumptions.

Yes, the likelihood of negative real returns is diminished over long holding periods, but your range of likely return outcomes remains far more uncertain than traditional rhetoric would suggest.

As I noted in my previous post, over the longer term, there is also a greater risk of unexpected “black swan” type events wiping out your investment. As Alexander Ineichen says, “if accidents happen in the short term, one might not live long enough to experience the long term.” Furthermore, by putting all our chips on the long-term appeal of equities, we are unwittingly making some very big assumptions. When you consider the aging of our population, who’s to say that equity returns will be as strong in the future as they have been over the past few decades?

Once again, let’s look at the case of Japan, where the TOPIX share index is still 60% below its 1990 high.

As Ineichen says:

The first dotted line assumes the Topix Index starts compounding at 4% per year. In such a scenario the index would reach its all-time-high from December 1989 around the year 2035.

Equities are expected to rise in the long run, i.e. time is supposed to diversify/reduce risk. However, from January 1990 to March 2011 the Topix TR (total returns) Index compounded at an annual rate of -4.4%. That’s the trend.

The second trajectory in Chart 6 shows the index assuming compounding continues at -4% per year. In theory, buyers should come in when there are valuation differences. In practice, the theory doesn’t seem to hold up very well. We do acknowledge that mean reversion is one of the most powerful concepts in finance (dead cats nearly always bounce). However, it doesn’t always seem to work. Or it might take too long to be a practical concept to bet on. There is uncertainty regarding the reversion to the mean.

So what are the practical implications of all this? You don’t have to believe we’re turning Japanese to be troubled by the chart above. The point is that long-term equity investors are subjecting themselves to enormous uncertainty.

This doesn’t mean we shouldn’t invest in equities for the long term. For people willing to put in the research, there will often be good shares available at a good price. But it does suggest the standard advice that young savers should have close to 100% of their retirement funds in growth assets such as equities, is far more dangerous than is commonly appreciated. As The Prince has noted in his excellent series on superannuation, the so called “balanced” default option for most Australian super investors is not balanced at all.

A truly balanced option would have a far greater allocation to fixed interest (including cash). Just don’t expect your financial adviser to tell you this in a hurry.

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  1. Alex Heyworth

    The only real lesson you can draw from the example of Japan is never to invest in any market that is experiencing a bubble. It should have been obvious to anyone in 1990 that the Japanese share market was at a completely unsustainable level.

    The sensible approach is to reduce your exposure to markets that have done well by taking profits, reinvesting those profits when the market has lost its froth. You don’t need to be able to pick the top and bottom, just be patient and not too greedy.

    Of course, this is against human nature to some extent, hence difficult for most of us. We tend to want to be with the herd.

    • Conversely, does it mean that we should be investing in the Nikkei? You wouldn’t have too many advisors and pundits suggesting so.

  2. I manage my own super now after discovering my provider had achieved approx 2% over 15 years. I’ve only had my SMSF going 12 months, but I’ve achieved a lot more than 2%. What I understand now is that big super providers can’t adapt to the market as they are the market so any big move has generally large consequences potentially. I have no idea about their philosophy, but a buy and hold just won’t work now IMO, and in my life time I don’t think it’s worked either. I follow the big US investment banks operations on the ASX and they are in/out/in. I know why they do this now so I can follow suit, and hopefully continue to get better returns.

    I don’t know what is going to happen long term, but I’m quite confident we’ll see a big market correction in the next few years.

    I’m confident in the future of our markets, but only if we get a non Labor/Greens government. I think without that change, our markets are in for an uncertain future.

  3. The answer to the blog heading is a clear NO. It’s usual to look at the past 30 years performance of the Nikkei as an example but there are many more. The Nikkei didn’t regain its 1919 peak until 1948. The FTSE peaked in 1824 and didn’t grow beyond that level until 122 years later in 1946. The FTSE is now still below its 1999 level.
    Over the long term, real assets seem safer than financial assets.

    • I think the answer is yes.

      but heavily dependant on not owning the “average” or as we call it the index

      the reason I go to work in my business is that I can make more money then sitting on an investment and watching the “rent” or “interest” or “dividends” roll in …. so where do you get access to business(es) … only via equities. therefore selective pickings sectors etc should be a good thing.
      volatility and risk are 2 seperate things.
      I think you should be “taking profits” off the table regularly, lock in the gains and remember Gekko “greed is good”
      if all else fails “short it”

  4. I don’t know why energy never gets brought into the debate about shares. We have our entire global economy based on oil for which the last 200 years has been increasing in production essentially driving economic growth. Just look at the 20th century compared to any other. Progress on that level will never be achieved again.

    Now we have a situation where we have a world addicted to oil and that supply is peaking. There is no chance in hell people are ever going to see any kind of long term returns in equities if they invest now. No chance.

    “A fit human adult can sustain about one-tenth of a horsepower, so a human would have to labor more than 10 years to equal a barrel of oil.”

    • Yep, peak oil is another of the big long-term uncertainties that could drastically affect share prices. We just don’t know, and that’s the point. Best not to put all your eggs in one basket.

      • Not a quantum change though – it’ll be reflected in price adjustments as supply dwindles and prices increase. Which will make currently unprofitable reserves profitable whilst also making more expensive alternative more attractive. The wonders of the market..

        • Yep. And all these big changes, whether it be peak oil, aging societies, global warming, etc, will create investment opportunities of their own too. As Grantham says, wait for the China crash and then load up on resource companies. They aren’t going away in the longer term.

  5. Risk can be managed. Uncertainty cannot be managed (via risk metrics). The future is uncertain.

    “It is impossible for the profits of all or of the majority of enterprises to rise without an increase in the effective monetary circulation (through the creation of new credit or dishoarding)”.F. Machlup, The Stock Market, Credit, and Capital Formation (1940), p. 90.


    From the article: Similar charts are often used to argue that young savers (in their 20s and 30s, for example),-to separate the owners of capital and deliver it to the usurpers of capital.

    Also there is currency debasement risk over long periods. That is your “phantom” gains are akin to “winning” on the Zimbabwe stockmarket. Your stock gains are usually below losses in currency inflation/translation..
    Confetti wins for people who want to marry stupidity.

    • Good point re: currency debasement risk / inflationary risk …. one of the least talked about notions among econo and lay-people alike (that you paper is worth less with every day).

      • Completely ridiculous. If you keep up with the world of finance, you will see that most economists are very concerned about inflationary risks going forward. The idea that this is a “least talked about notion” is preposterous. What Seanm has said is nothing new or incredibly insightful, it is something real finance experts are thinking about every moment of the day.

  6. they will be good when no 1 is buying like when the asx was at 3k…maybe 1k next time who knows

    • Burb, what happens when the paper isnt excepted? All the currencies in history have become worthless, even the gold got debased.

  7. As an equities guy I think good shares at a good price are a safe bet in the long term. Of course determining what is a good share and what is a good price is the hard part. I wouldn’t buy Qantas shares. Ever. Yet there are plenty of people out there who own the stock – presumably because they think its a good company or thy’re a funds manager who must follow the ASX200. But for every dog year QAN has, a JBH, WOW, COH or REH will have a good year with good rewards for it’s shareholders

    • I completely agree with this. Good shares at a good price.

      My issue is really with just buying the index, or paying a fund manager to hug close to the index. That may have worked in previous decades. I don’t think this will be the case in the next couple of decades. Which raises pretty big questions about the average super fund allocation, as The Prince has written much about…

      • Especially considering the baby boomer demographics. Leaving behind less people to buy assets from the larger, older, retiring generation is a recipe for asset price deflation.
        If only I could find a listed grey-care company that was worth a damn.

    • i don’t think wow is a good company … how have they performed in the las t 2 years … or 5

      prefer ugl

      • Err..they’ve grown equity per share at a fast clip in both the last 2 and 5 years Jack.

        Eq per share has doubled from FY2006 to FY2011

        True, their share price hasn’t (yet) reflected this growth – it probably went a little overboard during the 2003-2007 bubble, but is now behind in terms of growth in book value.

        And the future is not clear (when is it for any stock?) with an unknown return on the Masters DIY big-box hardware rollout and the reducing reinvestment ratio and of course, the anti-oligopolptic move by now powerful Independents against WOW, WES etc…

        • WOW is phenomenal. its text book buffett business. actually not sure why he hasnt taken a stake? totally agree with you prince. as for peak oil. all fields peak and decline. globally oil production peaked in 2005-06 i think. however we are not going to have some catastrophic meltdown of the global economy. just a shift to more pricy and lower calorific fuels (nat gas, oil sands etc). its a question of marginal pricing and adjustment.

  8. RA, thank you very much for this post – I’ve been reading Alexander Ineichen’s “Regulonomics” PDF you attached and found it fascinating – pure gold (even though the underlying subject matter was boring as batsh#t – European insurance company risk assessment)

    I hope to continue this discussion this week. I’ve got two posts coming up:

    1. Why there are only two “risk” profiles, or types of investors: The Amateur and The Professional
    2. My solution to Super asset allocation – the Asymmetric Barbell Portfolio

    Should be a fun discussion….

    • Cheers Prince. Yes, that Ineichen piece is gold – I am a huge fan of that guy.

      And really looking forward to your next post – and proposed super solution, particularly as I am moving back to Australia soon and have to start thinking about this issue myself!