Monday Morning – Long-run home run: Diversification

Here is a disturbing thought: What if stocks aren’t always the best bet long term?

Certainly, during a recent long run – from 1926 to the end of 2002 – stocks outperformed bonds of all kinds.

During that period, large-cap stocks returned 10.2%, compounded annually, before fees and trading costs, according to Ibbotson Associates in Chicago.

Meanwhile, small-cap stocks returned 12.1%, compounded annually, corporate bonds returned 5.9%, and long-term governments returned 5.5%.

But how many investors really have a 77-year investment horizon? The answer: very few.

For most, the long run is far shorter. Few can look as far ahead as 40 years. For many, 20 years is about as far out as they are comfortable considering, even though their true investment horizon may be far longer.

As Canadian pension consultant Keith Ambachtsheer of Toronto-based K.P.A. Advisory Services Ltd. recently pointed out, just because stocks have generated higher returns than bonds during the past few decades doesn’t prove that “a 5% equity risk premium versus bonds is assured in the long run.

“Indeed, when history is segmented into a series of sequential, coherent investment regimes, a very different conclusion emerges,” he notes.

Mr. Ambachtsheer divided investment history into periods based on investor pessimism or optimism over periods lasting 10 to 20 years, and found that the equity risk premium varies greatly depending on the investor’s mind-set.

For example, he says, investors were pessimistic during the decade encompassing World War I, and the equity risk premium for that period was -5%. That is, stocks offered a negative risk-adjusted return compared with bonds.

By contrast, the Roaring ’20s was an optimistic decade, with the equity risk premium at 12%.

The next 20 years were pessimistic ones, as they incorporated the Great Depression and World War II. The ERP was zero during that period. In other words, stocks paid no premium for the extra risk of holding them, an unsatisfactory state of affairs for a rational investor.

However, in the following two decades, which Mr. Ambachtsheer terms the Pax Americana I era, investors were optimistic, and the ERP was 8%. It was followed by the Scary ’70s, when investors once again became pessimistic, and the ERP was -3%.

Finally, the Pax Americana II era brought investor optimism back in vogue. Over the 20 years through March 2000, the ERP was 9%.

murky outlook

Now we seem to be three years into another period of investor pessimism.

And if Mr. Ambachtsheer’s analysis is correct, we have at least another seven years of poor equity returns ahead of us, and possibly as many as 17 years.

Another thoughtful Canadian, Martin Barnes, managing editor of The Bank Credit Analyst in Montreal, recently pointed out that the buy-and-hold investor would have done just as well investing in Treasuries as investing in the stocks in the Standard & Poor’s 500 index during the past 221/2 years.

That is, if you extend Mr. Ambachtsheer’s Pax Americana II period another three years, the equity risk premium essentially drops to zero.

“Wall Street’s dirty secret is that in the 34 years since February 1969, stocks have outperformed long-term Treasuries by a paltry 1% a year, on average. That is a dismally small gap, given the extra volatility in stocks,” says Mr. Barnes.

“The equity outperformance over that period all occurred in a short period between late 1979 and late 1980, when bonds were crushed by the Fed’s new high-interest-rate policy,” he adds.

So there can be 20- and 30-year periods where stocks don’t outperform bonds on a risk-adjusted basis, where you would be better off investing in Treasuries and sleeping well at night than investing in stocks and suffering tortured, sleepless nights.

The difficulty, of course, lies in knowing in advance when to be in stocks or in Treasuries.

Perhaps Mr. Ambachtsheer’s analysis gives a clue. If you can read the level of optimism or pessimism among investors and determine whether its causes are long-term or short-term, you might be able to position yourself correctly in stocks or bonds.

But the best solution is the diversified portfolio encompassing both major asset classes.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.