If you have a spare 20 years, investing in shares is supposed to be a no-brainer.
Time in the market; the line slopes up.
But in a new paper, Research Affiliates (RAFI) founder, Rob Arnott, says history offers alternative lessons, too.
“Our industry largely ignores the low but hardly negligible possibility of negative real returns over a shockingly long span. This myth lingers despite a very recent 22-year span, from 1999 to 2021, in which the returns of ordinary long U.S. T-bonds eclipsed those of the S&P 500, and a 14-year span, from 1999 to 2014, in which the S&P 500 index, net of inflation, never recovered from the dreadful first decade of the 2000s.
“… roughly once every generation stocks enjoy a stupendous bull market, rising to a new high that is roughly twice the previous high, in real terms. In the intervening years, spanning over 80% of the past 222 years, investors waited, often for decades, in a different sort of ‘punctuated equilibrium,’ hoping for the market to claw its way back to prior peaks. Once a secular bull market came to an end, that wait took an average of 26 years.”
In the third in a series of articles based on his contribution to the 50th anniversary issue of the Journal of Portfolio Management (JPM), Arnott has more bad news for those expecting endless decades of share market outperformance.
“Over the past 222 years, the correlation between prior and subsequent rolling 10‑year real stock market returns has been a whopping –38%,” he says. “When stocks offer terrific real returns in one decade, they tend to reverse course over the next decade, and vice versa.
“… Mean reversion is a powerful force: the further stocks stray from historical norms, the more likely they are to revert.”
While history might point to some salutary warnings for share investors, Arnott says the past provides fewer clues in divining the future equity risk premium (ERP) – or the excess returns above bonds.
For example, the analysis of 222 years of US market data found the annual ERP over rolling 10-year periods ranged from almost 19 per cent to -13.4 per cent.
Arnott says 10 years represents “a reasonably long investment horizon” for most people but “few would consider a 19% annual risk premium reasonable, and no one would consider a –13% risk premium reasonable. These are backward-looking “excess returns,” not forward-looking risk premia.”
“… Forecasting the future ERP by extrapolating past excess returns—even measured over scores of years—is a popular but pernicious blunder. Even so, much of the finance community sets return expectations in exactly this fashion.”
The paper also debunks a common assumption that the long-term excess return of equities over bonds amounts to about 5 per cent based on almost a century of data.
He says the observed 98-year ERP of roughly 4.5 per cent as at the end of 2023 was pumped up by a “tremendous upward revaluation” of the US stock market in the latter half of the 20th century.
“Absent rising valuation multiples, the 98-year history would have delivered an excess return of 3.2%, not 4.5%,” Arnott says.
“… past returns, even over a span longer than most of us can hope to live, are a terrible way to set return expectations.”
The study also says the ERP is unstable over time, dividends matter and investors need to distinguish between “true and false buybacks”.
“Most ERP myths resemble classic urban legends,” Arnott says. “They are so seductively plausible that they linger despite overwhelming evidence to the contrary. Most of these myths can be used to rationalize a higher, not a lower, ERP. No one seems to want to construct a myth or a fable that might lead us to expect lower returns!”
The RAFI founder also addresses the state of finance theory, the efficient markets hypothesis and the dangers of relying on back-testing to forecast future alpha in the JPM series of papers.