Investment lessons from 122 years of stock market data

Faith Glasgow picks out key trends that long term investors can take advantage of.

In these days of global unrest, rampant inflation, and interest rates on the rise, investors may find themselves wondering where the next body blow to returns will come from.

So it is timely that Credit Suisse has recently published its highly respected Global Investment Returns Yearbook for 2022, which draws valuable lessons for today from 122 years of financial data. Although the American novelist Kurt Vonnegut described history as “merely a list of surprises” to prepare for, the authors point out that “long-run financial history has much more to offer than just to ready us for the next surprise”.

The Yearbook draws on data from 35 countries, running back to 1900 and spanning two world wars, pandemics, financial crashes, inflation and deflation, as well as periods of peace, economic booms and huge technological advances. So it is well-positioned to provide useful insights into investment performance across the long and short term.

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Equities the best-performing asset class

The long view remains a positive one. Over the past 122 years, equities are still the best bet as investments, with a global portfolio providing an annualised real return in US dollars of 5.3%. In contrast, corporate bonds have produced an annualised 2% real return and government bills 0.7%. Moreover, equities have outperformed both fixed interest holdings and inflation in all 35 markets under scrutiny.

However, in the near term, a dramatic increase in inflation and the associated risk of interest rate hikes are hurting both equities and bonds.

The Yearbook emphasises that although stocks are likely to outpace inflation across the course of an economic cycle, returns are nonetheless damaged by rising prices. As the authors comment: “It is important to distinguish between beating inflation and hedging against inflation.”

The difficulty for asset managers and indeed for private investors, as Mark Northway, investment director at Sparrows Capital, points out, is that there is no easy alternative to equities. “We face an environment in which traditional asset classes are expected to underperform, and where cash doesn’t provide safe harbour,” he says.

Northway adds: “The authors suggest that allocating to defensive stocks and large caps may provide a better outcome, and that the environment is potentially more promising for active managers; but they caution that stock selection and market timing skills are widely claimed but rare in practice.”

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Rising base rates also work against returns: for example, historically, US stocks have returned an annualised 3% during periods of rate hikes, while fixed interest barely stayed in positive territory, with bonds up 0.2% a year. In contrast, when interest rates are falling, US stocks return an annualised 9.7% and bonds 3.7%.

So, with rate hikes very much on this year’s agenda, are returns likely to be lower looking ahead? The authors are cautious about making forecasts. “The results above are long-term averages spanning many different economic conditions. They conceal considerable differences between cycles,” they warn.

The authors add: “Furthermore, the prospective rate rises have been well signaled, and should therefore be largely priced in. In addition, central banks and governments will also not wish to choke off the post-pandemic recovery.”

Diversification ‘the only free lunch in finance’

The Yearbook also highlights the benefits of diversification - “the only free lunch in finance”, in the words of US economist Harry Markowitz. By diversifying, investors lower overall volatility, enabling them to “earn the same return with lower risk, or a higher return for the same risk”.

Investors should therefore diversify both within and across equity markets, and also across asset classes.

But there are no guarantees attached to spreading your bets. In fact, the relative strength of the US market and its lack of volatility over the past 50 years, together with currency fluctuations, mean US investors would actually have been better off sticking to a portfolio of domestic stocks.

Could that continue going forward? As the authors point out, hindsight is a wonderful thing. Looking ahead, “it is hard to predict which countries will perform best or where domestic investment might beat global. There is no obvious reason to expect continued American exceptionalism. Surely, US corporate superiority should by now be priced in?” They therefore advocate global diversification for everyone - including US investors.

Northway adds: “The Yearbook speaks directly to conversations we are having daily with investors. We try to incorporate the academic output into our portfolio construction, for example through diversifying across asset classes and geographically, and incorporating index-linked bonds.

“Portfolios will always be exposed to market swings, but these techniques are intended to reduce risk and access long-term market premiums efficiently.”