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Where the long-run returns lie

Markets are volatile, with much variation in year-to-year returns: we need long time series to make inferences. The periods we examine must be long enough to incorporate the good, the bad and the indifferent times.
In this article we provide an update on long-run returns on stocks, bonds, bills, and inflation. We draw on the Global Investment Returns Yearbook 2005 recently published by ABN AMRO and London Business School. This report analyses the long-term investment record for 17 countries over the 105-year period from 1900 to the start of this year. The yearbook complements broader research presented in our book, ‘Triumph of the Optimists’. This year, in addition to new research (not included here), we have added a new country, Norway, to our database.
Figure 1 shows the cumulative total return on UK stocks, bonds, bills, and inflation from 1900-2004. Equities performed best, with an initial investment of £1 (E1.40) growing to £14,988 in nominal terms by end-2004. Long bonds and treasury bills gave lower returns, although they beat inflation. Their respective index levels at the end of 2004 are £247 and £176, with the inflation index ending at £61. The legend in figure 1 shows the annualised returns. Equities returned 9.6% annually, versus 5.4% on bonds, 5.0% on bills, and annual inflation of 4.0%.
Since retail prices rose by a multiple of 61 over this period, it is more helpful to compare returns in real terms. Figure 2 shows the real returns on UK equities, bonds, and bills. Over the 105 years, an initial investment of £1, with dividends reinvested, would have grown in purchasing power by 245 times. The corresponding multiples for bonds and bills are 4.0 and 2.9 times the initial investment, respectively. As the legend for figure 2 shows, these terminal wealth figures correspond to annualised real returns of 5.4% on equities, 1.3% on bonds, and 1.0% on bills.
Figure 2 shows that UK equities had negative real returns over the first 20 years of the 20th century, but then experienced steady growth, broken by periodic setbacks. These occurred at the start of the two world wars and in the early 1930s.
The largest equity decline was in 1973-74, the period of the first OPEC oil squeeze after the 1973 October War in the Middle-east. Oil prices rose from $3 (E2.2) per barrel to nearly $12. This drove the world into deep recession. In the UK, this was aggravated by labour unrest, political uncertainty, and poor economic management and monetary policy, which led to inflation spiralling to a peak of 25% in 1975.
Figure 2 indicates that this had a major negative impact on bond returns. Investors who kept faith with equities were eventually rewarded, however, and shares rose by 97% in real terms in 1975. From the bottom of the 1973-74 bear market, UK equities showed strong gains for 26 years - the October 1987 crash is just a tiny blip in figure 2 - until the bear market of 2000-02, followed by the partial recovery of 2003-04.
Chart 3 shows annualised real equity and bond returns over the last 105 years for the 17 countries in our long-run database. This exhibit sets the UK performance record in perspective. Countries are shown in ascending order of equity market performance: without exception, equities were the best performing asset class. The real return was positive in every country, typically at a level of 4-6%.
Real bond returns were generally lower and more mixed. While in most countries they were positive, figure 3 reveals that five countries experienced negative returns. These countries were also among the worst equity performers. Mostly, this poor performance dates back to the first half of the 20th century, and these were the countries that either lost major wars, or were most ravaged by war and civil strife. These same countries also had periods of high inflation or hyperinflation, typically associated with wars and their aftermath.
Figure 3 shows that the UK was a middle-ranker among both equity and bond markets. Our newcomer, Norway, ranked 13th out of 17 equity markets, with a real return of 3.5%. Norway was 7th out of the 17 bond markets, with a real return of 1.7% . The US performed well, with real equity and bond returns of 6.6 and 1.9% annually, respectively, placing it in 4th position for equities and 5th for bonds.
Until our research appeared, the US market had been the only reliable source of long-run returns data. Consequently, investors around the world had tended to base forward-looking projections on US evidence. Many have cautioned about the dangers of this practice, since the US economy has been such an obvious growth and success story. Figure 3 provides the evidence to set this debate in context. It shows that while US stocks performed well, the US was not the top performer; nor were its returns especially high relative to the world averages. Figure 3 shows that over the last 105 years, the best performing equity markets tended to be resource-rich and/or new world countries, while the worst markets were those most afflicted by wars and civil conflict.
It is clear that equities performed best over the long run in all 17 countries. It would be worrying if this were not the case, as equities are substantially riskier than bonds or bills.
Bear markets underline the risk of equities. Even in a lower volatility market such as the UK, losses can be huge. During the 1973-74 bear market, UK equities fell by 71% in real terms, and in a single year, 1974, the real return was 57%.
At the start of the 21st century, equity markets gave another timely reminder about risk. When the
bottom of the three-year bear market was reached
in March 2003, US stocks had fallen 45% from
their start-2000 level, UK equity prices had
halved, and German stocks had fallen in price by
two-thirds. The substantial gains since then have helped mitigate these losses. However, as of early 2005, 21st century real equity returns remain
negative in 10 of the 17 countries.
In order to understand risk and return in the capital markets – which is the principal objective of the Global Investment Returns Yearbook – we need to examine much longer periods of history than five years. Stock markets are volatile, with considerable variation in year-to-year returns. We need long time series before we can make inferences. While the 105-year returns are much less favourable than the returns of the tech-bubble era, they contrast sharply with the disappointing returns over 2000-04. In doing so, they provide a reassuring reminder that, over the long run, the higher risk from investing in stocks has been rewarded.
Triumph of the Optimists is published by Princeton University Press. The Global Investment Returns Yearbook is available from London Business School, price £100. Both books are co-authored by Elroy Dimson, Paul Marsh and Mike Staunton.
Copyright © 2005 Elroy Dimson, Paul Marsh and Mike Staunton, London Business School

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