Brent Sheather: Don't be too sure that stocks are a long-term winner

By Brent Sheather

There is no shortage of information on investing in the sharemarket for mum and dad contemplating equities as a home for their savings. Trouble is that much of it, for one reason or another, is dead wrong.

Take past performance as an example many people think that it's the bottom line as far as picking what's going to do well in the future. Technical analysis or charting is all about discerning the future from the past and extrapolating trends.

Financial planners all over the world pay to get performance statistics for hundreds of thousands of managed funds investing in various asset classes - New Zealand shares, US shares, global shares, emerging markets, property and bonds - because mum and dad want to know, as one local Italian investor puts it, what's a going a good?

Remember back in 1999/2000 trying to sell NZ shares to clients was hopeless. All they wanted was international shares with a bit of technology if you were really up with the play. Buying past performance is popular and easy to do but the odds are stacked against such a strategy because, as common sense tells us, it's already gone up.

These thoughts and several other good ones are argued in a paper entitled What Did We Learn From the Great Stock Market Bubble for a forthcoming issue of the US Financial Analysts Journal.

The author is Clifford Asness, of AQR Capital Management of the US.

Asness is a frequent contributor to the Analysts Journal and the Journal of Portfolio Management. He has a PhD in finance from the University of Chicago and, prior to co-founding AQR Capital, was a research director of Goldman Sachs. He has also lectured at Yale and the Massachusetts Institute of Technology (MIT). AQR manages US$13.5 billion ($19.9 billion) and is based in Greenwich, Connecticut.

The paper, to be published next month, is a breath of fresh air and should be compulsory reading for would-be stockbrokers and financial planners even though the reality of working in the investment industry is often such that profitability depends on perpetuating the myths rather than embracing the facts. For example, refusing to sell what's hot based on past performance is generally not a great career move.

Asness' gems are written from the perspective of what we have or should have learned from the Great Stockmarket Bubble of 1998/2000 and, in so doing, he summarises much of the most important, recent research on sharemarket investing.

Long-term average stock returns are a poor forecaster of the future

That this truth doesn't get much airplay is due to the fact that it materially threatens the economics of the savings industry. Managed fund salespeople need historic high-equity returns to continue to make their fees look reasonable but the truth is that high historic returns don't mean high future returns.

Asness uses the example of investors, back in 1999, calculating the return on US stocks from 1946 to 1999. That analysis would have showed an average historic return of 8.4 per cent per annum above inflation. Great historic performance so everyone piles in, but then, over the next five years, the annualised return was actually negative 5 per cent pa. Asness says: "The main point is that after periods of strong returns, trailing average returns are higher, and since these periods almost always come with increases in valuation, future expected returns are actually lower ... "

Higher prices today means lower expected returns tomorrow

This point is related to the one above and an understanding of it is critical for anyone investing in shares or property. Asness looks at the valuation of the US sharemarket for every 10-year period between 1927 and 2004 and sorts each of these into six categories according to their average price-earnings ratio then calculates the return in the following 10 years.

His data shows that buying shares at high prices generally means lower returns in the future. More common sense. The sort of sense that also tells us that shares aren't guaranteed to outperform houses or bonds or cash for that matter if share prices are too high.

Asness says: "Next consider the hallowed property of equity returns; that stocks never lose if held for the long term. Well, if a decade is your idea of the long term, then this is only true when prices start out at or below average. When they start out expensive, there are decades where stocks not only lost to inflation but lose big." So there goes "hold for the long term and you'll be okay", out the window along with "buying last year's winners".

We can also see the sense of this point if we go back to that economic formula which says returns = dividend yield plus the growth rate of earnings. When prices are high (like now) dividends are low (2 per cent) and, thus, future returns are likely to be lower than at times when dividends are higher.

What this also suggests is that all that good advice saying "time in the market" is more important than "timing" are, well, wrong. If you buy in at a time when prices are high even 10 years may not be long enough to beat inflation.

Next week more of Asness' revelations including "why dividends are good", "earnings don't grow at 10 per cent a year" and "why international diversification is not a waste of time".

* Brent Sheather is a Whakatane-based investment adviser.

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