Those of us 50+ may remember the Pogo cartoon series and the infamous line;
Equity market risk is considered the reason most investors do not invest in, or stay invested in equities. The US firm Dalbar reports annually how equity market investors consistently underperform the equity market itself! With long term growth of the equity market consistently positive, we have to wonder, why do most investors feel the equity market is risky and why are equities volatile?
Ibbotson and Associates completed research on the performance of different asset classes (equities and fixed income) over the longest period for which data was available (which was from the US). The following is the average annual returns, (assuming dividends and interest was reinvested) : for the period 1926 to 2013
Equities – Large Cap Companies 10.1%
Equities – Small Cap Companies 12.3%
Fixed Income – Long-term, high quality corporate bonds 6.0%
Ibbotson also determined that the long term Consumer Price Index (inflation), using the governments’ method of calculation, has compounded at 3%. To get the real return from equities (after inflation) we simply subtract 3% from the long term returns:
Equities – Large Cap Companies 7.1%
Equities – Small Cap Companies 9.3%
Fixed Income – Long-term, high quality corporate bonds 3.0%
We can conclude that over the last 90 years, through two world wars, a depression and countless financial and other crisis, the ownership of companies (equities) provided an average annualized compound return after the increase in cost of living of 2 to 3 times the average return of lending to quality companies (owning corporate bonds).
So, why doesn’t everyone invest in equities given the virtual certainty (given time) that owning the shares of good companies would (over the certainty of time) net investors 2 to 3 times the reward of loaning to those companies?
The most common answer is, well, equities are riskier than fixed income and could go down!
But wait a minute, it’s true that over 90 years of data, equities have gone down and individual companies even decline to zero, but collectively a broad portfolio of equities such as would be purchased within an equity mutual fund, does not stay down! If the definition of risk is the potential to lose your money, then over long periods (or just waiting a few years for the inevitable recovery), a broad portfolio of equities or a diversified mutual fund should not be considered risky.
A better answer to why many investors feel the equity market is risky and do not invest in equities or those that do, don’t make the historical returns is, volatility. Volatility, however, which is a temporary decline and always results in recovery within a few months or years, is not risk, which is the chance that a broad portfolio of equities would go down in value and never recover.
Temporary declines happen so regularly we really shouldn’t be surprised. The average intra year decline is about 14% and we have experienced 13 or more declines greater than 15% over the last 40 years.
Many investors and economists prefer to believe volatility is the result of instability of the economy or corporate earnings. Here again, when we look at longer time frames, the economy (with recessions included) chugs along at just under 3% (as measured by Gross Domestic Product) including recessions. Corporate earnings similarly average 5 to 6% growth over longer time frames.
So once again, if the equity market, economy and corporate earnings show consistent growth over longer periods, why the feeling of risk and degree of volatility in equity markets? A recent paper from Morningstar “Optimal portfolios for the long term” found that, “investors require a larger risk premium during recessions and are more risk tolerant during an expansion. This creates short-run volatility through regular swings in prices.” So in simple terms, investors buy high and sell low – they pay more than they should in strong economies and won’t buy when they should in weak economies. Given this seems to be as the result of human nature and human nature does not change, equity market volatility won’t change.
So, most investors continue to feel the equity market is risky, despite the historical evidence to the contrary and do not invest or stay invested in equites because of volatility (both up and down!) which is created by investors who buy high and sell low.
We have met the enemy ….