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"This long run is a misleading guide to current affairs. In the long run, we are all dead."
Pithy quotes like this set John Maynard Keynes apart from other economists.
Of course, Lord Keynes is absolutely right -- in the long run, we are all dead. However, one interpretation of this comment is that investors should beware of projecting past trends into the future, as this approach frequently proves unsound.
When shares beat bonds
For example, it is a matter of historical fact that, over the longest periods, the returns from shares have comfortably beaten those from bonds.
Indeed, according to the Barclays Equity-Gilt Study, shares produced an average "real" return (after inflation) of 5.4% a year from 1960 to 2010. Gilts (U.K. government bonds) returned a mere 2.5% a year over the same timescale. Thus, over this half-century, the additional 2.9%-a-year return from equities provided a huge boost to investors' returns.
Then again, as I often remark, "averages invite comparisons," and, over these 50 years, the returns from shares have been extremely volatile for long periods. What's more, the returns I've quoted are for one specific period for one particular country, so they are by no means universal.
When bonds top shares
In fact, there have been lengthy periods in modern history when bonds beat shares.
For example, between 1968 (the year I was born) and 2008, U.S. Treasury bonds produced higher real returns than U.S. equities. Over these 40 years -- almost my entire life -- American investors would have made more from boring, safe bonds than from risky, volatile shares.
Alas, this result isn't confined only to a particular four decades in the stronghold of modern capitalism. It's happened in other major nations, too.
In an analysis titled Long-Term Asset Return Study: A Roadmap for the Grey Age, top analyst Jim Reid of Deutsche Bank found other examples of long-term underperformance by shares. Reid found that, since 1962, bonds have beaten shares in three leading economies: Germany, Italy, and Japan.
Four decades of disappointment
I'm not surprised that Japan falls into this category, as the performance of its stock market has been dire since the Nikkei 225 index peaked at nearly 39,000 in 1989.
Today, the Nikkei stands at around 8,700, a level it first breached in 1983. On average, Japanese share prices are no higher today than they were 28 years ago, producing near-zero returns for "long-term buy and hold" (LTBH) investors.
However, the inclusion of Germany comes as something of a shock. Despite its amazing postwar industrial recovery, the Bundesrepublik's economic success has not translated into strong returns for equities. In real terms and since 1962, German investors would have been better off in Bunds than in German equities.
In Italy, the outperformance of bonds is extreme: The real return from bonds is 3% a year higher than that from shares. This adds up to four decades of deep disappointment for Italian shareholders.
What should investors do?
Clearly, while LTBH has been shown to work over many different periods and in many different markets, it is not a hard-and-fast route to superior returns. There is no Golden Law of Investing stating that equities always outperform bonds, even over a lifetime of investing.
However, LTBH is a widely used shortcut or rule of thumb to justify heavy exposure to shares. Then again, how much exposure would you have liked to Russian stocks in 1917, just before the October Revolution and state seizures of your assets?
Nevertheless, LTBH is a cornerstone of investing and lies at the heart of millions of portfolios. To me, Reid's research suggests that investors should tweak their LTBH strategy as follows:
- By all means, hold a decent proportion of your wealth in shares. However, for safety's sake, you should balance these equity holdings with significant exposure to high-quality government and corporate bonds. An "all-in bet" on equities is far too risky and volatile for all but the most hardened investors.
- Rather than assuming that your homeland will be a future winner, spread your equity investments around the globe by buying foreign shares. If your local stock market proves to be a dead duck, then you still have some exposure to overseas stock markets.
- Pay close attention to the income generated by your investments. When average earnings yields and share dividends are low, shares may be overvalued (as was apparent toward the end of the '90s boom). Conversely, when the FTSE 100 dividend yield is high, this may suggest some degree of undervaluation.
Of these three points, the third seems critical to me.
After all, most investments (with the notable exception of gold and other commodities) can be valued based on their future incomes. As I explained last week, with the FTSE 100 dividend yield at 3.8% and 10-year Gilts yielding a fixed 2.2%, blue-chip shares are extremely likely to produce much greater income than these bonds over the next decade.
Hence, I'm of the view that shares offer better value than Gilts and, therefore, U.K. equities will outperform U.K. government bonds over the next decade. After the "lost decade" since 2001, shareholders can but hope!
Finally, Jim Reid at Deutsche Bank reckons that real returns from U.S. equities over the next five years will be -2.6% a year, but 0.6% a year over 10 years. Even so, as Reid expects 10-year Treasuries to return -2% a year until maturity in 2021, shares still seem the better bet.
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