What caught my eye this week.
The 1970s were a legendarily tough decade – for investors, for the UK economy, and for lovers of understated fashion. In his deep dives into the biggest equity swoons and bond market blow-ups, my co-blogger The Accumulator invariably showcases some horror story from the decade that time strives to forget.
Yet as parents and sports coaches alike counsel, it’s from the toughest times that we can draw the biggest lessons.
“High pressure makes diamonds” as people who fire themselves up in the mirror every morning before hitting the M25 like to say.
Which is all good reason to check out the extract from William Bernstein’s new book over on Humble Dollar this weekend.
Once more without feeling
In Courage Required, the veteran investing author reminds us that cheap markets aren’t so easily bought as they appear in hindsight.
Everyone thinks they will buy at the bottom. But in practice you’ll face both practical and psychological roadblocks.
Including Bernstein argues, human empathy:
Empathy […] at least financially, is one expensive emotion, since channeling the fear and greed of others often comes dear.
The corollary to human empathy is our evolutionarily derived tendency to imitate those around us, particularly if they all seem to be getting rich with tech stocks and cryptocurrency.
My own unscientific sampling of friends and colleagues suggests that the most empathetic tend to be the worst investors. Empathy is an extraordinarily difficult quality to self-assess, and it might be worthwhile to ask your most intimate and trusted family and friends where you fit on its scale.
To use a Yiddish word, the more of a mensch you are, the more likely you are to lose your critical faculties during a bubble and to lose your discipline during a bear market.
As somebody who has previously sold some possessions to buy more shares in the midst of bear markets, I’m not sure how to take this.
(Well, I guess I would take it personally, but my apparent lack of empathy protects me…)
Oh well, I’ve always known I think differently. And what equips one poorly for trouble-free dinner party conversation often seems me to be an advantage as an active investor.
Do read the full article over on Humble Dollar and consider getting the latest edition of Bernstein’s book – The Four Pillars of Investing – too.
(Or wait a bit. We might review it soon.)
Have a great weekend!
From Monevator
Which commodities ETF? – Monevator
Leveraged ETFs for the long run* – Monevator [Mogul members]
From the archive-ator: The index fund investor’s guide to avoiding financial hazards – Monevator
News
Note: Some links are Google search results – in PC/desktop view click through to read the article. Try privacy/incognito mode to avoid cookies. Consider subscribing to sites you visit a lot.
Ben Bernanke to lead review into Bank of England’s forecasting – B.O.E.
St James’s Place shares slump on Consumer Duty charge cap – Investment Week
Big lenders cut mortgage deals in sign rates may be peaking – Guardian
Number of households paying IHT jumps 17%; average bill £214,000 – This Is Money
Why productivity is so weak at UK companies [Search result] – FT
Ovo under fire as hundreds of customers claim bills incorrect – This Is Money
How UK house prices left the middle class behind – Guardian
Products and services
Halifax offers an extra-speedy £150 bank account switching offer – This Is Money
Have children’s savings rates kept up with base rate rises? – Which
Transfer your SIPP to Interactive Investor in July and get from £100 to £3,000 in cashback, plus pay no SIPP fee for six months. Terms apply – Interactive Investor
“I’m secretly a Coutts customer but for people like me there’s no point” – Guardian
Help to Buy mortgage meltdown forcing some homeowners to pay 9% interest – This Is Money
Five things to know about credit reports and credit scores – Which
Open an account with low-cost platform InvestEngine via our link and get £25 when you invest at least £100 (T&Cs apply. Capital at risk) – InvestEngine
ASDA boosts cashback offer on its credit cards. Is it any good? – Which
Victorian homes for sale, in pictures – Guardian
Comment and opinion
Another buy-to-let landlord skedaddles – Indeedably
The dark side of money – The Root of All
Wall Street’s market forecasts: all hat, no cattle – Fortunes & Frictions
The return on hassle spectrum – Of Dollars and Data
Why do thematic funds fail? – Behavioural Investment
Eight ways you can maximize the power of compounding – Finominal
Tips to avoid being scammed on social media – Humble Dollar
Are the markets stacked against the little guy? – A Wealth of Common Sense
Cullen Roche: is cash the best insurance asset? – Discipline Funds
The case for an indexing approach to managed futures [Nerdy] – CAIA
Naughty corner: Active antics
The Nike story [Podcast] – Acquired
Choosing a discount rate – Capital Gains
Don’t expect net income growth of US firms to continue to outrun fundamentals – Verdad
Professional investors are still so scared – Sentiment Trader
‘Disastrous’ SPACs and ‘painful’ IPOs wiped out years of gains – Institutional Investor
Kindle book bargains
Money Men by Dan McCrum [On the Wirecard fraud] – £2.99 on Kindle
The Ride of a Lifetime by Bob Iger – £0.99 on Kindle
How to Own the World by Andrew Craig – £0.99 on Kindle
Environmental factors
July 2023 is the hottest month ever recorded on Earth – Scientific American
When deep-sea miners come a-courting – Hakai Magazine
How farmers used California’s floods to revive underground aquifers – R.T.B.C.
ESG put to the test in a high-inflation world [Search result] – FT
Gulf stream could collapse as early as 2025, study finds – Guardian
Robot overlord roundup
Investing in AI: navigating the hype – Sparkline Capital
Publishers want billions, not millions, from AI – Semafor
Meta’s open source Llama upsets the AI horse race – Wired
The Office repeats mini-special
Ghost town Canary Wharf – The Daily Mail
Don’t schedule meetings after 4pm – Vox
AI, remote work, and office demand – Dror Poleg
Why can’t we shake presenteeism? – BBC
Off our beat
The Comfort Crisis – Mr Money Mustache
How CIA agents begged a Hollywood actor to explain crypto – Rolling Stone
In praise of great lost products, from Cheese Moments to the Skip It – Guardian
The weird sorrow of losing Twitter – Vox
How to craft a good life [Podcast] – Good Life Project
I hate the Hamptons – We’re Gonna Get The Bastards
Visiting death – Overcoming Bias [via Abnormal Returns]
And finally…
“Life is essentially an endless series of problems. The solution to one problem is merely the creation of another.”
– Mark Manson, The Subtle Art of Not Giving a F*ck
Like these links? Subscribe to get them every Friday. Note this article includes affiliate links, such as from Amazon and Interactive Investor.
I am a great fan of William Bernstein’s investment books. I already own the first edition of The Four Pillars of Investing. I shall read all excerpts and reviews intently to see how much new material is in the new edition and whether it is worth buying.
Some additional Interactive Investor news, from the FT yesterday:
> The UK’s second-largest investment platform said on Friday its lowest priced option — £4.99 a month — would be available from September to those with up to £50,000 to invest, up from £30,000, while it raised the price on its middle-ranking “core investor” plan by 20 per cent to £11.99 a month.
I’m loving the “Comfort Crisis” (MMM article and the book itself).
It is really articulating my (and my close friends’) thoughts on the need to keep challenging ourselves on everything from faith, fasting, exercise, physical challenges, and holding middle age at bay for as long as possible.
Investment Week on FCA Consumer Duty impacts on SJP’s fees and shares = get out world’s smallest violin. 16 March 2023 Yodelar.com reported: “80% of SJP funds performed worse than half of same sector over 10 years”. Ongoing reduced fee of 0.85% p.a. (down from 1 % p.a.) to be available to 65,000 of 941,000 SJP clients.
The trouble is, there are plenty of conspiracy theorists and other nutjobs who consider themselves to be ‘independent thinkers’ (and who probably lack empathy too). And there is wisdom in crowds, eg on ‘Who Wants to be a Millionaire’ the audience usually get it right. I defer to the 97% of scientists who believe global warming is real and man made, and the 90% of economists who argue Brexit will make us poorer as a country (sorry not sorry for the shoehorn).
On the other hand, there is madness in crowds too, as the numerous market bubbles over the years demonstrate. ‘Group Think’ also is a real phenomenon. And as Warren Buffett says, we should buy when others are fearful and sell when others are greedy (or words to that effect). So I would argue some independent thought is important.
I do think if you’re going to go against the crowds then you’ve at least got to do a lot of research and thinking and analysis to be sure of what you’re doing, and have a healthy dose of self doubt as well (something conspiracy theorists generally lack), ie a willingness to challenge one’s own views and assumptions.
(Well, I guess I would take it personally, but my apparent lack of empathy protects me…)
Brilliant
The Four Pillars of Investing was my entry point to investing. Its a great book – both informative and entertaining. Few other investing books manage that. The only negative, for a non-US investor, is that the financial products and tax strategies it describes are US-specific. I think I shall buy the 2nd edition of the book.
I agree wholeheartedly about the difficulty of buying during a big bear market. I well remember in 2008 thinking that this was probably a once-in-a-lifetime buying opportunity, but at the same time with everything collapsing there were very plausible narratives that the situation could turn into something even worse than the great depression. I sat on the sidelines and missed the big gains, when I should have been brave and followed TI’s call to action in 2009
I do wonder how Bernstein comes to these sorts of conclusions since he’s never actually been a professional investor or trader. It’s never quite as simple as too much of some behavioural aspect (say empathy) being bad and too little good. I’ve seen situations where a lack of empathy has been a real danger in a market panic or liquidity air pocket. You’d be acting too early and be carted out.
July 2023 is the hottest month ever recorded on Earth and the Tory party has suddenly decided the environment doesn’t matter anymore.
I found ‘The dark side of money- The Root of All’ fascinating but was horrified that 46% on the Twitter poll would exchange the death of a random person for $10,000.
I was thinking of buying ‘ Mark Manson- The Subtle Art of Not Giving a F*ck’ but just hoping it wouldn’t result in me joining the 46% cohort.
I have mixed feelings on MMM’s “Comfort Crisis”. On the one hand, I agree with many of his points around challenging oneself. In fact, I think it’s something I wrote about on this very site in the “FI debates”.
On the other, I urge people to be vigilant on the proliferation of “no pain, no gain” culture. Many advocates (including MMM) take it too far prescribing lifestyle or medical choices that are sometimes dangerous and they are not qualified to make (even if he caveats these in his article, he shouldn’t make these statements in the first place).
Unfortunately, over the past few years I developed a few chronic illnesses, to go along with one that went undiagnosed since childhood. Through that lense, I often see ableism. In this specific example, MMM is fortunate to have “won the genetic lottery”. For him, standard daily life is not a struggle. He is in the privileged position that he can choose how much pain and struggle he can add to his life. For many people with chronic illness, disabilities or unfortunate circumstances, their lives are a constant struggle and fight.
The corollary of this is that people unable or unwilling to empathise with the plight of others sleepwalk themselves into either a misguided diagnosis of society. This ranges from today’s society is too weak/woke/insert whatever your political ideology is through to seeing seeing people with disabilities as morally lacking or those with divergent gender forms as deviants. You may argue I’m over egging the pudding, but look only to the political discourse over the past decade. Or if you don’t buy that, the horrific proliferation of “bro science” and toxic alpha-male guff that is infecting many of our boys and young men.
Bernstein piece: trading v investing all over. Different psychologies. Never let trading become investment or vice versa. But not every investment is a failed trade. That only applies to traders. Traders can’t afford to tolerate losses, whether it’s tins of spam or securities. Investors can, but often don’t. Their problem less empathy surplus /deficiency & more survival/greed. See paper loss & sell, maybe ‘avoiding’ more paper losses. But it always looks like it will get worse before it starts getting better. Narratives (CNBC, Bloomberg etc.) naively extrapolate from what only just happened. They’re a trailing measure, not a forward indicator. All that matters is where you end up compared to goals, not pathway. You can’t control path. Just know that at some point in the future you will pay more to invest. And those who sell can’t buy back in, whether market falling or rising. If it falls, they feel vindicated and hold out for more. If it rises, they either don’t believe in it or can’t bear to buy in again for a higher price than they sold for. So they stay uninvested, sitting on the sidelines, until they either give up entirely or end up buying back in at still higher prices. Latter was me in 2008-13. Learn from my mistake. If investing, stay invested. More money (opportunity cost) has been lost avoiding crashes than has ever been permanently lost in the crashes.
For clarification on not selling, #10 refers to investing in global equities (i.e. in MSCI ACWI & FTSE All World index trackers). No matter how bad things appear (e.g. the 1979 Business Week ‘Death of Equities’ piece, quoted by Humble Dollar), global equities will, eventually, make you whole again. The world economy will not simply disappear, even if some companies do. Contrastingly, individual shares may never recover after falls. Bailing out on them can and often does make sense.
@TDM – Sorry to hear about your health issues. Hope you are able to recover. I went back and re-read the MMM article but didn’t really see anything explicitly dangerous in it save possibly the bit about the lake. Maybe you were referring to other articles in his back catalogue?
That said, I do have a similar outlook in as much as I naturally recoil when I hear people berating the poor/sick/unlucky in the media suggesting they should all just try harder. Its hard to appreciate just what a monumental effort it can be for some just to get through the day, let alone live some sort of aspirational dream life that the MMM brand portrays.
All in all, probably best to have a bit of empathy up your sleeve even if Bernstein has deemed it sub-optimal from an investing perspective.
Also agree on the bro-science and alpha-male movement, it does seem to be proliferating and is very unattractive stuff. I haven’t really delved into it but is Huberman the poster-boy for this sort of stuff? I know TEA has been raving about him so I assume he is probably to be avoided, much like other pet subjects such as crypto and testosterone.
I saw an article in the guardian where Tate and Peterson were mentioned in the same sentence and I thought that was a bit unfair though, one is a criminal thug and the other is, as far as I can make out, a serious academic who just happens to be a rare combination of being both right wing and a psychologist? Working hard whilst at the same time having to contend with very serious mental health issues.
The one thing all these people have in common though, including MMM is an absolutely overwhelming propensity to self-publicise. I understand that this can be a route to great success but there is a bit of me that thinks this personality trait is rarely without some sort of underlying unwelcome issue.
Thought your previous articles were great, hope you can pen some more in the future if health/head-space/time allows!
@TI:
Thanks for an interesting set of links as usual.
The This is Money IHT link caused me to source the original report – which I believe is available at: https://www.gov.uk/government/statistics/inheritance-tax-statistics-commentary/inheritance-tax-statistics-commentary
Figure 3 in the source report [AERT vs net value of estate] was not included in the This is Money report. However, it may be of some interest to Monevator readers. What caught my eye was the pronounced inflection above 7.5m and to a lesser extent the plateau from c. 2.5m to 5m.
@TDM “This ranges from today’s society is too weak/woke/insert whatever your political ideology is through to seeing seeing people with disabilities as morally lacking or those with divergent gender forms as deviants.”
To be honest, I’ve never liked MMM, except possibly in the very early iterations. First, he is real fan of pop psychology. He much prefers to wax lyrical about that sort of cargo cult science than actually dive into the numbers of FIRE. He knows his market only want to hear “can do”.
There is also something about the way he communicates that echoes some of the more libertarian parts of the GOP. You must be super self-confident, super fit, super at work, super at bloody everything. Being different is only ok if that different is being better. There is no room for weakness, anxiety, depression or any disability. It’s seems all very libertarian but, in reality, it’s often very prescriptive. Don’t like it at all.
@TLI (#16):
Some more AETR commentary in this 2018 report from the OTS:
https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/758367/Final_Inheritance_Tax_Report_-_web_copy.pdf
NB I understand that the OTS report uses a slightly different flavour of AETR.
I also suspect – although I am far from sure of this – that Figure 3 in the ONS Report is making its first appearance “to inform the public debate around Inheritance Tax”.
@Ducknsald Don #9
“July 2023 is the hottest month ever recorded on Earth and the Tory party has suddenly decided the environment doesn’t matter anymore.”
…And empathy of (the crowd) investors. From this article on Morningstar https://www.morningstar.co.uk/uk/news/237619/esg-flows-stall-as-global-headwinds-hit.aspx
It would seem that the whole investing world is becoming less empathetic this quarter compared to last, especially so outside Europe. And I wish the article had drilled down into European areas to gauge the feeling of our own Brexited land, Europe still leads the world with inflows to ESG funds, the Tories seem to have shot themselves in the foot with poll ratings over their actions regarding this.
I will add that I am only using this as a gauge of opinion and that I am not convinced ESG investing is the answer, I do not trust free market economy to save the planet, that needs leadership, we just need the right leaders.
JimJim
[NB: In case anyone wonders why it’s vanished, I asked @TI to delete my comment which used to be at #16 (obviously the thread’s now renumbered) as, in the second part of that, I was a bit unfair to MMM and, on reflection, the way I expressed the politics was OTT.]
I enjoyed the MMM article and would consider borrowing the book from the library. It may even have inspired me to brave the rain and cycle in as usual (saving me £6:80 in tube fares) this morning.
The Guardian’s Coutt’s article was rather odd, if the author is genuinely uneasy with Coutt’s then switch banks. I can only assume that it was silly season filler.
@Rhino – thank you for the kind words, I am very grateful for them.
It’s interesting to hear how your perception has differed to mine from the piece. I will say at this point that, probably for the past 5+ years, I only ever read MMM when it is linked here. I soured on his website (and to a lesser extent him) a long time ago. But that’s by the by.
There’s three bits that jumped out to me.
First: “… deeper and deeper analysis of a neverending series of exotic and mysterious and unsolvable problems with their physical and mental health” – these types of comments are almost always directed at dismissing or trivialising complex psychological or physical illnesses. They also often identify individuals who believe these conditions don’t exist or are overdiagnosed. I their view, it’s a lack of moral backbone that these people suffer – with a bit more gumption they’d get over it. This is a “red flag to a bull” for lots of us who’ve had to encounter and fight through medical gatekeepers.
“heavy exertion including with weights” – this is common refrain among theses types of commentator. If man lift heavy things he’ll be fine. I now see a specialist physio. He remarked to me that doing this was the single worst thing I could have done (on the recommendation of my GP at the time). His view was that for most people doing so was both unnecessary and harmful.
“should you expect that more exotic and niche medicines and treatments are the only course of action” – put simply, non-medical practitioners should just not be saying these types of things (however much caveated). You often see them raised against anti-depressants, treatments for ADHD and other complex psychological conditions, and symptom relievers for chronic illnesses. The implication is if only those people paddled on the lake more these conditions would (somehow magically) disappear.
I apologise to TI if that is all rather forensic. However, I thought it may be helpful to others if they see this language deployed (for a recent example, look at the farrago around ADHD following “that” panorama documentary).
All this can lead to people like MMM concluding that if only society was less lazy, people were less weak then people wouldn’t be disabled. It’s a nonsense. If you want to hear it from an expert, I recommend listening to the excellent “You’re Dead to Me” podcast episode “Disability in the Ancient World”.
@TDM @Others — The Details Man has a pass to talk about anything he likes and however off-topic it is on this site. 😉 He’s a star in our eyes! (And I obviously share @Rhino’s sentiments.)
I am an unabashed MMM fan. I accept his style is not for everyone. @TA used to dislike him but was won around.
The reality is that nobody is for everyone. If they were, then this site might have gazillions more readers rather than a very self-selected cohort of above-averagely bright/articulate readers with the attention span to plough through our long articles versus a TikTok video.
I will say that I am uncomfortable with the idea that somebody can’t present his own worldview on his site using language which may be ambiguous or open to interpretation, or which may seem sub-optimal if a particular person reads it, but which overall is positive, inclusive if strident, and is certainly not even close to inflammatory let alone hate speech. People see the world differently, and perhaps it’s my age but I do get a bit triggered by the idea that we have to write with every last person in the world in mind. Of course I equally respect the view that somebody might be completely turned off or even hostile to the view/tone, as some commenters are saying here they are with MMM. More than fair enough. That is pretty much my point. 🙂
I am not going to diagnose people’s long-standing health issues online, and I presume I’d be equally reluctant to do so as a doctor! So NOBODY least of all TDM should take the following as directed towards themselves. It’s absolutely not.
What I will say is I’ve had a bunch of chronic issues in my life that turned out to be (a) very real and (b) not as ‘structural’ as they appeared to be, including to the medical profession. This has included extremely fundamental gristle and gore stuff that at the time put me into surgery. Not least because of these experiences I am more tolerant of a wider spectrum of views on what drives illnesses and other maladaptions.
Again, that is not AT ALL to say illness or disability does not exist. One of my friends had to stay in isolation for two years over the worst of Covid due to his having multiple bouts of cancer reducing his lungs to 1/4 of their normal size by the age of 20. ‘Man-ing up’ to someone’s idea that he just faced ‘a cold’ especially early on when we had no vaccines and there was more uncertainty might have been deadly. But this was, to @TDM’s point, the implication of certain messaging he heard in the wider narrative.
I don’t think there’s a simple solution to this issue. I’m pro-kindness. But again, I am not pro-catering to every reader edge case, nor to thinking we all must think the same.
It’s complicated. 🙂
@Time Like Infinity: is there any explanation I can read on WHY global equity will always win out in the long run?
Surely if we all know that in 10 years time global stocks will be priced higher in real terms than they are today, the price would immediately rise accordingly ( discounted for some years’ loss of earnings)?
Just don’t understand why it happens so consistently.
@Valiant #23: A huge question, which I can’t do justice to (esp. in a short form thread reply format). So my apologies in advance that this is not a very good reply, even for a skeletal one.
One short answer is that it’s the equity risk premium. The ERP is required by rational investors to justify the increased volatility and sequence of return risk as against other asset classes. So, equities should be ‘structurally’ (perhaps not quite the right use of that term in a technical sense, but you get the idea) priced to deliver very long term risk adjusted total real returns above those of cash; short, intermediate and long term government debt; real estate etc.
However, as I understand it, the ERP alone can’t explain why it is that equities have, over the very longest time scales, more or less consistently outperformed not only less volatile/safer assets but also more volatile/less safe ones, like gold and commodities.
I also worry that that line of reasoning applied naively might induce investors to invest in all sorts of dubious propositions simply because they yo yo all over the place price wise – e.g. nonsense like (in my opinion) so called crypto ‘assets’ (which I personally regard as the biggest scam in the history of the world).
Big disclaimer and caveat alert (cue loud klaxon here):
– I don’t work in any area of finance at all.
– Nor do I systematically or professionally research finance.
– I don’t hold financial qualifications (I am a qualified professional in my own field, but that field is not to do with finance).
So, mine is an amateur, retail level, DIY investor’s perspective; and definitely not that of a professional with recognised experience (‘skin in the game’) and/or expertise, of which I have neither. Basically, I don’t know what I’m talking about here (!). So you have been warned.
That out of the way, I think another thing, over and above the ERP, which is going on is that companies collectively capture the growth of, and the changing dynamics of growth within, the global economy via (respectively) accruing profit share and also undertaking adaptations and innovations (R&D, reinvestment, and new systems of work), which collectively have the effect of driving both their own and wider productivity / efficiency gains.
Not sure how that would fit in with common pricing frameworks like the Capital Assets Pricing Model, but in my opinion, for all the great many and varied downsides, this makes diversified global equities an excellent very long term (multi decades horizon, rather than just multi year) asset class to invest in.
Some literature that I’ve read occasionally suggests that investing in either or both of smaller capitalisation firms and/or in Private Equity/unlisted companies carries a higher ERP and return in expectation because (amongst other considerations) of a form of illiquidity premium. I can’t comment on that with any weight, as I’m not qualified to assess such claims. It sounds plausible, but that doesn’t make it true.
I enjoyed Sigel’s “Stocks for the Long Run”, and would recommend reading that. No need to go out buy the current edition new though, as the wisdom in it is timeless. Got my copy remaindered for a few quid in what was Borders.
I’d offer a slightly different take. Stuff like ERP is effectively a made up economic concept and thus a way of analysing and explaining rather than what actually drives performance.
My quasi naive take is that there is no guarantee it will always win (past is no guarntee of the future) but it would take somewhat of a major meltdown in the way the world behaves to seriously dent equities. Equities by and large end up being invested in businesses that make and do (or aspire to make and do) useful stuff so as long as there remains demand for stuff then equities should ultimately endure. It would take e.g. a rise in uber-nationalism (no trade with outside countries) or even a possibly eco-led return to self sufficiency on a family/village level to seriously dent in the long term.
Then of course there is the Ponzi scheme aspect. Short selling activists or possibly alt investment bros aside it is in no-one’s interests for equities to fail as a store of value. Which helps sustain the model.
Separate post because while tangentially related it’s something I’ve sometimes pondered. If Boglehead philosophy ultimately prevails and the majority of global equity investment ends up being made through index funds does this make the future of equity more or less certain?
I’m thinking of the actors that see index funds as slow moving, reactive sheep and can use that behaviour to shear them. Maybe it all balances out as other actors come in to steal the shearings etc.
@Valiant. Most asset classes, when looked at over the long term, have a relatively similar return per unit volatility. Half a unit of return per unit volatility is a good rule of thumb. So volatility matters. People fear losses. Over time most of the short-term volatility net outs (mean-reverts), resulting in higher volatility asset outperforming lower volatility ones in return terms (and sometimes even in volatility terms). So an equity risk premium is not hard to understand.
What is more difficult to understand is the size of the equity risk premium. It seems too large. Other asset classes with similar volatility do not perform as well. Equities outperform lower risk assets by too much. This is termed the equity premium puzzle (EPP).
The EPP has a variety of possible explanations. Perhaps investors are simply too risk averse short term (myopic loss aversion). They systematically overestimate the risk and underestimate the long-term return of equities. More rationally it might be because they cannot accept a low but not insignificant probability of ruin (tail risks). Path dependency (sequence of returns) clearly matters to most investors.
It could be that we are measuring the equity premium incorrectly and the EPP is a statistical illusion. Most asset classes suffer from survivorship bias. Some estimate that taking account of that would reduce the equity premium by up to 40%. Other argue by measuring equity premium in the local currency (say the USD for the S&P), we miss the currency may itself be devaluing.
It also that we may be seeing a sample bias in the window period that we are looking at. Capitalism, democracy, globalization, rising standards of living all create a positive feedback loop for equities. Similarly, rising populations may help. Japan’s demographic decline may be a reason for poor equity returns. If we’ve had an equity market in 4th century Roman Britain, the returns between the 5th and 8th centuries would probably not have impressed!
We simply don’t know.
Hi Time Like Infinity and ZX. Thanks for the explanations, these are great.
Do you know where I could try for further reading on this? Would a Google search on EPP be right; have struggled before to construct a suitable search term?
I haven’t done reading on this but is part of the EPP explained by the size of the equity market and that investors don’t all behave in the same way (to have buyers and sellers at any point this is obviously true) nor necessarily entirely logically (by which I mean having a deliberate or inertia led non intervention strategy) e..g while some may be happy to execute stop losses and minimise downside, others may be more passive or bullish and ride out downturns. Thus the “perfect” market behaviour of a deep fall corresponding to risk is never realised.
Maybe the size of the market and number of players actually negates this idea anyway i.e. it is the market liquidity that ultimately means that equities outperform.
Sorry if this is just dumb musings, not a pro in any respect. Just curious as to those deeper into this.
Thank you @Valiant #28 and @ZX #27. It is a puzzle isn’t it?
The EPP must go back to the early 1800s as Sigel takes his data for the US ERP and equity returns from then onwards. I recall that others have pushed the data back a little to the 1790s, and that it only slightly reduces the figures, by about 0.5% p.a. for returns for example.
Siegel gets to a 6.5% p.a. real, total return for US equities (i.e. after inflation, before tax, and with all dividends immediately reinvested at no frictional cost) over a little more than 200 years. That’s about a cumulative real return of several 100,000x over the whole period of two centuries. Decennial returns fluctuate a lot within those two centuries, obviously, but there isn’t particularly a trend towards higher or lower returns.
Barclays Global Equity Gilt studies going back to 1956 give a lower figure for global real terms, total equity returns since 1900; and that figure currently sits at around 5% p.a. over the whole period from 1900 to date. That makes sense because back in 1800 the US was a minor frontier market whereas now it is the global hegemon, so you would expect it to have significantly outperformed.
Looking back a bit further, companies limited by shares really took off with the Dutch Republic, the world’s first truly capitalist society, back in the late 1600s. Because shares were traded face to face in taverns and coffee houses, rather than on an exchange, there’s precious little reliable information on share prices and returns before the last 200 years, and no way to establish what the ERP might have been back then.
But what we can say fairly unequivocally is that investing in 2023 is very different to in the past.
Index funds only started in the 1970s and did not really take off until the 1990s. ETFs are not much more than 30 years old. Discounted fund platforms in the UK only go back to the early 1980s (with the launch of HL). US mutual funds really got going only from the 1920s, and most people who owned shares brought individual securities, and not funds, for decades afterwards. Investment Trusts only go back to the 1860s. Even into the 1940s and 1950s there still were big spreads on most shares. Real time (or even low lag) share prices were not available. I remember people having to check closing prices from the previous day in the back of the newspaper.
So investing has now become very easy, highly informed, low cost and, because of the ability to effortlessly diversify, much lower risk.
This does not bode well for the ERP over the very long term.
The less risky and less difficult something is basic economic theory tells us the less rewarding it should be.
But, then again, theory and reality do not always align.
Even if the ERP reduces in future because equity investment continues to become ever more accessible to greater numbers of investors (with the catch up growth of Asia and soon also Africa between them creating billions more investors), it should, all things being equal, result in higher valuations (PEs) than in the past, especially as the number of exchange listed companies is tending to fall over time due to Private Equity buyouts.
So, whilst someone from back in 1900 might be shocked to see companies now regularly priced by the market at 25-30x earnings, and might well think that 15x earnings is more appropriate (based upon their own experience of the different difficulties and risks of investing back in 1900); so in 2100 investors might not blink at routinely paying 50x earnings.
Their expected returns will be lower than ours are because of that, but the difficulty and risk of them investing in equities will also be lower as compared to ours now.
Similarly, our expected returns will be less than those of an investor in 1900 who faced greater practical issues and risks when investing than we do now.
Ben Carlson in the ‘A Wealth of Common Sense’ blog put his finger on it recently when discussing equity valuation methods (it might even have been in the Monevator weekend reading links a couple of weeks ago) when he noted:
“The current CAPE at nearly 30x inflation adjusted trailing 10 year earnings certainly looks high relative to the 17.4x average if we go back to when Ulysses S. Grant was president”.
The world’s moved on a lot over time and as circumstances change so too will valuations, expected returns and the ERP.
@Valiant. There is a whole area of literature on ERP and EPP so searching for those terms will bring in a slew of stuff. I can’t help much since equities are not my area and it’s all too based on economic theory for my liking.
Mehra and Prescott did the original paper in 1985 and Mehra updated that in 2003 (https://www.academicwebpages.com/preview/mehra/pdf/FAJ%20-RM.pdf).
@Valiant & @ZX #27 & #31: Open questions here might include: Does the ERP describe and explain anything meaningful? Is ERP just a brute fact, or is there a cause (and if so what)? Does the explanation (if any) for ERP lie in the cross section of returns with other asset classes, or is it found in the characteristics of equities themselves as an asset class (or a bit of both)? Is ERP high compared to a reasonable prior expectation for what it should be?
@BBBobbins #26: Direct Indexing should solve the problem of active investors (hedge funds) front running which can occur when index tracking funds and ETFs come to rebalance. Instead of having a share of an ETF or a unit of an OEIC which tracks an index, we’ll eventually all be able to directly own all of the index constituents in proportion to their weightings, and then rebalance according to a personal schedule. This will also be more tax efficient when done within a GIA, as it will enable tax loss harvesting. Direct Indexing is already becoming available for HNWs in the US. It’s only a matter of time before plebians like me get access to it over here.
@Valiant #23 (& ors) + @ZX #27 last para.: On concern that we just don’t have enough data going back far enough and that the last century or so may be anomalous for equity returns; whilst broadly agreeing with ZX here, the situation might be a little less bleak as it turns out that there is actually data for equity markets going back (in the case of the Amsterdam exchange) some four centuries. I’ve posted the link to it (as there’s also a lot of data in the source about value and momentum factor returns going back two centuries) at my newly added post #34 here:
https://monevator.com/factor-investing-bad-years/
You will see that @TI, at post #18 in that thread, had made a similar point to @ZX at post #27 of this thread.
@The Details Man As an occasional poster on Monevator, it would be much appreciated if you could go into details about how chronic illness can affect FIRE. I rarely see this covered. It affects asset allocation, the assumption about can work/could do back to work, whether state pension is available (chronic illness can affect state pension because a lot of the time state benefits are not available which is the assumption people have), mortgages/loans etc are not available because of finances not fitting intot eh system, where does needed healthcare fit into affordability (covered in A Muppets Christmas Carol) etc etc.
I rarely see such issues covered or even an awareness they exist, beyond an added line.
Ermine’s posts have been the most helpful because he has written about what happens when one’s income doesn’t fit into the system. For him, it was no ability to get a mortgage because his income was not the correct income required. TI also had issues.
And a lot of CI people also have other marginalised issues and may be forced to ‘retire’ and won’t have access to pensions, annuities etc and a lot of the usual stuff talked about until a long time after they have been forced to stop work.
/end rant