Recently, Business Insider featured a chart of long-term equity returns based on data from Bob Shiller.
The lesson was, the longer your time frame and the more patient you are, equities win. That`s been a lesson taught to generations. Based on this data, equities has become the foundation of any portfolio for anyone building a long-term investment plan.
While I would not necessarily disagree with equities being a major portion of a long-term portfolio, I would content that Shiller`s analysis is at best, exaggerated because of survivorship bias, and at worst, deceptive. It is reminiscent of glossy brochures and offering memorandums promising great things, but leaving out key details.
Survivorship bias exaggerates returns
I always laugh whenever someone cites the history of US equities as a template for calculating future equity return expectations. The latest Credit Suisse Global Investment Return Yearbook 2016 provides some perspective. The chart below shows the relative sizes of equity markets in 1900 and in 2015. The top 5 markets in 1900 were (in order): UK, US, Germany, France and Russia. In 2015, the size of the American market dwarfs all other markets.
How would you feel if you found out that someone sold you an investment by citing the most successful market (or stock) in the last 115 year? Would you feel ripped off?
Here is how Credit Suisse characterized the returns of US equities. If you had invested $1 in 1900, you would have received $1,271 after inflation in 2015. Sounds good?
Let`s consider how you might have fared had you invested in the fifth largest stock market in 1900, Russia. For a Russian holding stocks during that period, the depletion of your portfolio would have been the least of your worries after about 1917.
What if you had invested in the largest market in 1900? A terminal portfolio value of 465 after 115 years wouldn’t be bad, but it dramatically lagged the terminal value of a US portfolio at 1271.
For completeness, here are the other two major markets in 1900, namely Germany…
…and France, both of which suffered dramatically during the Second World War. Just like the Russian example, there were periods when the devastation of your stock portfolio would have been the least of your worries.
Imagine the next 100 year
This little exercise illustrates my point about survivorship bias in returns data. I am not questioning the accuracy of the return data of US equities during the 20th and 21st Centuries, but to hold them up as the model template for what investment returns might look like in the next 100 years is, at best, guesswork.
There is another level of survivorship bias that a lot of analyst neglect, namely survivorship bias at the asset class level. At the dawn of the 20th Century in 1900, most investments went into the bond market. Stock markets were relatively immature and equity investment culture was not well developed. If you went back in time to 1900 and knew nothing about financial markets, would you necessarily put a major portion of your portfolio into what amounted to an under-developed asset class?
Consider the following scenario 100 years from now. China becomes the dominant global economic power, after a number of fits and starts. Maybe someone 100 years from now will be showing a chart like this, but for Chinese real estate. Maybe real estate becomes the dominant asset class and takes over from equities. After all, we learned in Econ 101 that the three classic factors of production are Labor, Capital (stocks and bonds) and Rent (real estate). Why not property as a major asset class?
There are several morals to this story:
- Beware of survivorship bias
- Consider asset classes beyond the stocks and bonds when forming an investment plan
- Diversify, diversify, diversify