Brent Sheather: Stocks the sizzler of the century

Last month saw the publication of the 2006 edition of the Global Investment Returns Yearbook (GIRY) by professors Dimson, Marsh and Staunton of the London Business School with ABN Amro Bank of Holland.

The GIRY has quickly become the authority on the long-run performance of global stock, bond, bill and foreign exchange markets. It covers the investment returns of the main North American, European, Asian and African economies from 1900 onwards.

The long-term results for the world market average are just as they should be - shares, which are higher risk and should thus have higher returns, have indeed outperformed, returning 8.9 per cent a year in nominal (including inflation) terms. Well behind are global bonds at 4.7 per cent, followed by short-term deposits at 4 per cent.

In every country surveyed, shares beat long-term bonds and short-term deposits over the 1900-2005 period but the race was closer in some countries than in others. In Switzerland, shares have outperformed bonds by only 1.9 per cent a year, not much of a risk premium there, while in the United States shares are ahead by 4.7 per cent a year.

Interesting to note too that in several countries - Japan, Italy, France and Germany - bond investors are behind inflation even over the full 106-year period. The hyper-inflation of the 1920s (in Europe) and 1940s (in Japan) dealt a severe blow to holders of nominal, as opposed to real, assets.

Two important events colour this 106-year sample: The periods of hyper-inflation, which were particularly bad news for bonds, and the fact that shares got much more expensive.

This might imply that, assuming governments are now wise enough to avoid hyper-inflation in the future and that shares can't keep getting more expensive forever, the gap between bond and equity returns in the next 100 years could be considerably less than what we have got used to.

The professors' estimate is that globally shares will outperform bonds by about 3 per cent a year over the next 100 years versus 4.7 per cent in the 106-year sample.

The GIRY contains 106 years of data for 17 countries comprising more than 90 per cent of the world's sharemarkets by market value.

Any guesses as to the best stockmarket performer in real terms over the 106 years? Japan, China, Russia perhaps?

The answer is actually Sweden at 7.8 per cent a year after inflation, followed closely by our mates across the ditch in Australia at 7.7 per cent a year.

China and Russia aren't in the study because their sharemarkets had major interruptions over the period whereby shareholders lost virtually everything: in 1917 in Russia and in the 1940s in China.

Even the Japanese economic miracle was only good for an average of 4.5 per cent a year, less than the US at 6.5 per cent a year. This poor result is largely due to Japan's high inflation, which averaged 7.4 per cent over the period.

The worst-performing sharemarket over the 106-year period was Belgium, which managed only an average 2.2 per cent real return. Maybe everyone was too busy reading Tintin.

Germany had the dubious honour of recording the biggest sharemarket rise in any one year - 305 billion per cent in 1923. A real bull market. The trouble was though that inflation was 209 billion per cent. In the same year, investors in German bank deposits and government bonds lost everything to hyper-inflation.

Dr Dimson explained to me that German bond and bank investors didn't exactly lose anything in money terms; they got their interest and principal returned in full. It's just that the money they received wasn't worth anything.

It was cheaper to burn paper money than spend it buying firewood. Germans apparently went shopping with wheelbarrows full of money and, eventually, cigarettes became a more useful currency.

Dr Dimson's father holidayed in Germany in 1922 and as he paid his hotel bill in British pounds, which had appreciated hugely against the deutschmark, his holiday cost virtually nothing.

Such a reverse scenario whereby investors in low-risk assets lose everything whereas higher-risk investors with their funds overseas and in shares survived with their savings intact makes one realise that rejecting the simple logic of a diversified portfolio is a huge step which shouldn't be taken lightly.

Potentially compromising this sort of common sense logic is Finance Minister Michael Cullen's ridiculous proposals to tax capital gains on overseas shares outside Australia. Maybe history lessons should be compulsory for Treasury whizz-kids.

In two weeks' time, we will look at what the professors have to tell us about the impact of currencies on sharemarket returns.

Brent Sheather is a Whakatane-based investment adviser.