Blog RSS Feed:

Blog - Investing Notes

February 1, 2005 - Triumph of the Optimists (Chapter-by-Chapter Review)

On the advice of Victor Niederhoffer, we have obtained and read Triumph of the Optimists: 101 Years of Global Investment Returns by Dimson, Marsh and Staunton (2002). Vic says that "if you read one investment book, this should be it." The book is thorough, logical and concise. With scores of illustrative graphs and figures, its statistics are accessible and its style straightforward. Its message, however, is somewhat at odds with the title. Below is a chapter-by-chapter review of the insights in this book:

Chapter 1 - Introduction and Overview

Chapter 1 summarizes the organization of the book. Key points are that the work:

• Examines returns from and volatilities of equities, bonds and bills, also addressing inflation rates and currency shifts.
• Covers 16 countries comprising over 88% of current world market capitalization, offering context for increasing global economic integration.
• Assembles and organizes data across these markets for 101 years of history, from 1900 to 2000.
• Provides detailed analyses of important cross-sectional phenomena, including company size, value-versus-growth and seasonal effects.
• Focuses in its concluding chapters on the historical equity premium and on an estimate for and implications of the future equity premium.

In short, the book covers more markets over longer timeframes with a higher level of comparability than previous benchmarking efforts.

Chapter 2 - World Markets: Today and Yesterday

Chapter 2 characterizes country and industry compositions of world financial markets in 1900 and 2000, with some details (mostly for the U.S. and U.K.). Key points are:

• As of the end of 2000, the U.S. represents about 36% of world GDP, 46% ($16.6 trillion) of the world equity market and 47% ($14.6 trillion) of the world bond market.
• Relative country shares of the world equity market shifted considerably over the last century (from 22% to 46% for the U.S.).
• Industry compositions of world market also changed dramatically (for example, from dominance of railroads to prominence of information technology and consumer goods in the U.S.).
• The concentration of market capitalization among the largest companies varied over the century (generally falling in the U.S.).

In short, broad market dynamics of the 20th century reflect the ascendancy of the U.S., political turbulence and technological change.

Chapter 3 - Measuring Long-Term Returns

Chapter 3 lays out the authors’ criteria for assembling valid and useful financial indices for analysis. Key points are sound indices must:

• Avoid survivorship/success and easy-data biases, which can introduce substantial overstatement of returns.
• Focus on total returns, encompassing income and capital gain/loss.
• Apply proper weighting of components (based on market capitalization) and averaging (arithmetic rather than geometric averages for fixed investment periods).
• Maximize international comparability via common start date (e.g., 1900), measurement points (e.g., end of year) and currency perspective (e.g., U.S. dollar).

In short, methodological rigor is critical to ensuring that results of analyses represent possible real outcomes for investors. The book, however, does not attempt to include investor transaction costs.

Chapter 4 - International Capital Market History

Chapter 4 examines returns (nominal and real) and volatilities of stocks, bonds and bills across 16 countries for 101 years from 1900 to 2000. Key points are:

• Over the entire 101 years, nominal (real) compounded returns for U.S. stocks, bonds and bills were 10.1% (6.7%), 4.8% (1.6%) and 4.1% (0.9%), respectively. Standard deviations were 20.2%, 10.0% and 4.7%, respectively.
• Results for the U.K. were similar.
• Across all 16 countries, real compounded returns for equities ranged from 2.5% to 7.6%, and standard deviations ranged from 17% to 32%.
• Returns on bonds were lower than returns on equities in all 16 countries. In 5 of 16 countries, real returns on bonds were negative over the entire 101 years.
• Performance of markets varies across the century. The U.S. market offered significantly higher returns for stocks, bonds and bills over the final 25 years than over the first 75 years.
• Portfolio diversification is critical to risk reduction. Those investors without stock selection skills should seek to "own the market."

In short, the risks of owning equities have paid substantial excess returns over the past century.

In constructing these results, the authors assume reinvestment of all dividends and interest. They also assume no taxes and no transaction costs. Note that Faugere and Van Erlach question the feasibility of reinvesting all dividends broadly across the U.S. market in "A General Theory of Stock Market Valuation and Return".

Chapter 5 - Inflation, Interest Rates and Bill Returns

Chapter 5 examines inflation and interest rates across 16 countries for 101 years from 1900 to 2000. Key points are:

• Inflation in in the U.S. averaged 3.2% during 1900-2000, running higher in the second half of the century than in the first half. Nominal interest rates (bills) averaged 4.1% for a real average interest rate of 0.9%.
• The average inflation rate for all 16 countries covered was 4.9%, ranging from a low of 2.2% (Switzerland) to a high of 9.1% (Italy). Real average interest rates ranged from –4.1% (Italy) to 2.8% (Denmark). World wars tend to stimulate subsequent periods of high inflation.
• Real rates were notably higher worldwide during 1980-2000 (3.7%) than during the prior 80 years (-0.7%).
• Before 1950, there was no obvious relationship between inflation and interest rates. There has been a generally close relationship since. [Note that the Fed Model relationship between equity and bill/bond yields in the U.S. also snapped into place during the second half of the last century.]

In short, it is critical for long-term investors to include the effects of historically persistent and varying inflation in assessing returns.

Chapter 6 - Bond Returns

Chapter 6 examines returns on bonds across 16 countries for 101 years from 1900 to 2000. Key points are:

• Government bonds provided a real compounded return of only 1.6% during 1900-2000, with substantial risk (standard deviation 10%). However, U.S. bond returns were historically high during 1981-2000 with an 8.9% real annualized return. Over the entire century, high-grade corporate bonds offered an incremental 0.5% of compounded return as a default risk premium.
• The worldwide average real return on bonds was 0.5%, ranging from –2.2% (Italy) to 2.8% (Switzerland). Returns in the second half of the century were more even and positive across countries.
• The bond maturity premium over bills was just 0.7% in the U.S. and 0.5% worldwide, small with respect to the much higher risk (variability of returns).
• Inflation-adjusted bonds, available in the U.K. since 1981, have performed poorly due to high real interest rates.

In short, bonds were a disappointing investment over then entire period 1900-2000, offering relatively low returns and high risk. However, bonds did well in the U.S. and U.K. during the final 20 years of the last century.

Chapter 7 - Exchange Rates and Common-Currency Returns

Chapter 7 examines exchange rate fluctuations across 16 countries for 101 years from 1900 to 2000. Key points are:

• Currencies fluctuated widely relative to each other in the past century, with most weakening against the dollar.
• Wars, periods of high inflation, lapse of the gold standard, introduction and lapse of the Bretton Woods agreements and adoption of the current floating exchange rate system in 1973 drove currency fluctuations. Exchange rate volatility has been high under the floating system.
• Real exchange rates, however, were fairly stable, with local exchange rate and inflation rate differences tending to cancel (maintaining purchasing power parity).
• Real currency exchange rate fluctuations have been small compared to real equity returns.

In short, local exchange rate fluctuations have not presented a significant disincentive to diversifying internationally in equities over the long term.

Chapter 8 - International Investment

Chapter 8 examines the risk reduction benefits of international investing. Key points are:

• International diversification provides considerable equity and bond investment risk reduction; currency exchange risk is small over the long term.
• During 1900-2000, investors in most countries (but not the U.S.) would have been better off investing worldwide. During 1950-2000, U.S. investors would have benefited from international diversification.
• Barriers to international investing were high in mid-century and low at the beginning and end. Late in the century, higher correlations among markets lessened the risk reduction benefits of diversification.
• Even with barriers falling and international investment rising (from 1% of aggregate portfolio value in 1980 to 12% in 2000 for U.S. investors), portfolios worldwide are still heavily concentrated in home countries.

In short, unless investors have special insights regarding individual markets, they should hold the "world" portfolio.

Chapter 9 - Size Effects and Seasonality in Stock Returns

Chapter 9 examines the size premium and seasonal effects in equity markets worldwide. Key points are:

• The size effect (inverse relationship between company size and stock returns) is a feature of most world markets.
• During 1926-2000 in the U.S., nominal annualized returns on large, small and micro capitalization stocks were 10.6%, 11.9% and 12.1%.
• Soon after its discovery in 1981, the size effect reversed for the balance of the century in most countries, with smaller stocks underperforming large ones. However, the size effect still holds over the very long term.
• The size effect in the U.S. is wholly attributable to excess returns in January. Conversely, the January effect is entirely a small-stock phenomenon. The U.K. has no year-end effect.

In short, size and seasonal effects do exist but, once publicized, anomalies often disappear or reverse.

Our blog entries of 3/27/06 and 5/26/06 for summaries of recent research on size and seasonal effects in the U.S. equity market. January 2005 reinforced the reversal of trend finding.

Chapter 10 - Value and Growth in Stock Returns

Chapter 10 examines the value-over-growth premium for equity markets worldwide. Key points are:

• Value stocks beat growth stocks in the U.S. during 1926-2000. High-yield stocks generated an annualized nominal return of 12.2%; low-yield, 10.4%. High book-tomarket stocks generated 13.7% annualized nominal return; low book-to-market stocks, 10.2%.
• The U.K. experience over 1900-2000 was similar.
• Worldwide, based on various studies, the value-over growth premium has been about 3.2% annualized nominal excess return.
• Recent evidence for value over growth is mixed.

In short, value has generally beaten growth in worldwide equity markets.

Our blog entry of 10/13/04 for a summary of recent research on value advantage in the U.S. equity market.

Chapter 11 - Equity Dividends

Chapter 11 examines the importance of and trends in equity dividends during 1900-2000 across 16 countries. Key points are:

• Worldwide, aggregate dividend growth and equity market performance are highly correlated during the 20th century.
• Equity dividends in the U.S. market grew at an annualized real rate of 0.58% from 1900 to 2000, slower than GDP growth.
• In the U.S. and U.K., reinvested dividends would account for nearly half of an investor’s total annualized return from equities in the last century.
• As of the end of 2000, U.S. equity dividends were at a 101-year low (falling from 7.2% in 1950 to 1.1%) Moreover, there has been a sharp decline in the proportion of companies paying dividends to just 21% in 2000. Possible explanations for these trends: creation of many small growth companies; tax considerations; and, use of stock repurchases in lieu of dividends or dividend increases.
• In the U.S., the aggregate value of stock repurchases grew to match the aggregate value of dividends as of 1998. Stock repurchasing is much less in other countries.

In short, dividend reinvestment produces a substantial part of overall equity market returns, and aggregate dividend growth is a strong indicator for overall market performance.

Note that Faugere and Van Erlach question the feasibility of reinvesting all dividends broadly across the U.S. market in "A General Theory of Stock Market Valuation and Return".

Chapter 12 - The Equity Risk Premium

Chapter 12 examines the excess returns of stocks over bills and bonds (equity risk premium) in 16 countries during 1900 to 2000. Key points are:

• The annualized equity risk premium relative to bills during 1900-2000 is 5.8% for the U.S., 4.8% for the U.K. and 4.9% for a size-weighted worldwide index (ranging from 1.8% for Denmark to 7.4% for France).
• The annualized equity risk premium relative to bonds during 1900-2000 is 5.0% for the U.S., 4.4% for the U.K. and 4.6% for a size-weighted worldwide index (ranging from 2.0% for Denmark to 6.7% for Germany).
• These results are about 1.5% lower than previous (construction-biased) studies.
• The equity risk premium has high year-to-year variability (standard deviation about 20% for the U.S.).
• A very high equity risk premium is not synonymous with very high real stock market returns; a high inflation rate can dampen real returns for all asset classes.

In short, investors have gained about a 5% annualized excess return over the long term by investing in stocks rather than bills or bonds.

Our blog entry of 11/8/04 summarizes research on using the relationship between yields on stocks and T-bills as a market timing indicator.

Chapter 13 - The Prospective Risk Premium

Chapter 13 estimates the future equity risk premium for the U.S., U.K. and world markets. Key points are:

• Estimates of the future equity risk premium should start with historical results and then adjust for expected shifts in stock market variability and non-repeatability of unusual past cash flows.
• During 1950-2000, cash flows exceeded expectations as technology and management process improvements boosted productivity, generating 0.2% (1.7%) of U.S. (U.K.) ex post annualized equity risk premium.
• Also during 1950-2000, the required rate of return on investments fell as risk declined and opportunities for diversification increased, accounting for 1.4% (0.6%) of U.S. (U.K.) ex post annualized equity risk premium.
• Worldwide, 1950-2000 non-repeatable cash flows and risk reductions made 0.6% and 1.2% contributions, respectively, to the ex post annualized equity risk premium.
• In the 21st century, the ex ante equity risk premium will therefore have a geometric (arithmetic) mean of about 4.1% (5.4%) for the U.S., 2.4% (3.7%) for the U.K. and 3.0% (4.0%) for a size-weighted world index.

In short, investors should expect smaller excess returns for the risk of owning equities in the future than they enjoyed in the past.

Our blog entry of 12/16/04 summarizes updated commentary from the authors on the future equity risk premium.

For reasons why there may be positive cash flow surprises in the future, see our blog entry on the long-term productivity trend or consider the possible commercialization of nanotechnology innovations.

Chapter 14 - Implications for Investors

Chapter 14 advises investors on how the conclusions of prior chapters should inform investment strategy and tactics. Key points are:

• Because the future equity risk premium is likely to be lower than that experienced during 1900-2000, a stocks-to-bonds ratio of 60:40 is reasonable.
• With a declining equity risk premium, investors should be diligent in minimizing the drags on returns from taxes, transaction fees and mutual fund management fees. They should lean more toward buy-and-hold in tax-protected accounts via low-fee funds.
• Investors should guard against excessive bets on unexplained statistical anomalies (e.g., the January effect for small stocks).
• Skilled investors should risk incremental deviation from passive (index) investing because index returns will be declining.
• Because underperformance of equities in a single country can persist for decades, investors should diversify investments worldwide.

In short, plan for a falling equity risk premium and growing access to worldwide markets.

Chapter 15 - Implications for Companies

Chapter 15 advises companies on adjusting their decision-making to an era of international projects and a lower equity risk premium. Key points are:

• The forward-looking annualized real rate of return on equity capital from a global perspective is 6%. The arithmetic mean return is 7%, ranging from 4.8% in Belgium to 9.9% in Sweden (U.S, 8.7%). These estimates are lower than those from prior studies.
• With a lower required return on equity, more projects should qualify for corporate investment (companies may be underinvesting).
• Companies should incorporate a lower equity risk premium into their pension fund assumptions.
• Equity and debt return expectations do not imply changes in corporate capital structure or dividend policy.
• Policy-makers should consider reducing allowed returns for regulated businesses.
• International firms should hedge their short-term currency risk, even though such risk is small over the long run.

In short, company leaders should ensure that they do not anchor their financial management on obsolete (too high) equity return assumptions.

As noted in our comments on the prior chapter, historically strong information technology-driven productivity gains and other technological surprises may again drive the ex post equity risk premium above its ex ante benchmark.

Chapter 16 - Conclusion

Chapter 16 highlights key conclusions and implications of preceding chapters, as follows:

• 1900-1950 is a period of hot wars and an incipient, nuclear-weighted cold war. It brought crash, depression, deflation and hyperinflation. It was a worse than expected time for investors. Pessimists outperformed.
• 1950-2000 is a period of rising productivity, improving management and corporate governance, technological innovation and falling barriers to international trade and investment. It was a better than expected time for investors. Optimists triumphed.
• Statistical logic says that optimists will not triumph in coming decades. The equity risk premium will average (arithmetically) only 4-5%, significantly less than derived in prior analyses. In fact, only a permanently low equity risk premium can justify the high stock prices we now enjoy.

In short, 21st-century investors should curb their exuberance.

We see reasons for renewed optimism. There may still be considerable unrealized productivity enhancements from information technology, encompassing globalization (including labor supply), management and governance, as well as manufacturing and distribution. And, it may be more reasonable to view other technological innovation as accelerating (Moore’s Law) rather than reaching a plateau.

What timeframe best indicates what to expect for the future equity risk premium: 1900-2000, 1950-2000 or 1980-2000? We recently asked Amit Goyal whether there is some optimum interval of historical data for establishing a mean equity premium. He replied equivocally: "[A] longer time series provides more precise estimates but at the same time the world might have been different in early 1900s than it is now."

Part Two (Chapters 17-34)

Chapters 17-34 describe the global database used for the book and provide appendix-like results for equities, bonds, bills, exchange rate and inflation for each of 16 countries and the world overall during the period 1900-2000. Countries included are: Australia, Belgium, Canada, Denmark, France, Germany, Ireland, Italy, Japan, Netherlands, South Africa, Spain, Sweden, Switzerland, United Kingdom and United States.

For other research on the equity risk premium, see Blog Synthesis: The Equity Risk Premium.