Shares still make sense: Why “this time it’s different” is wrongheaded thinking

After several years of poor performance shares are good value, particularly against record low bond yields and low and falling cash rates. Against this, the investment backdrop remains as messy as it’s ever been over the last few years.

Europe is continuing to muddle along with many fretting it will blow apart. The US is going through a soft patch with concerns about a ‘fiscal cliff’ later this year. Key emerging countries have also slowed. While the Australian economy is doing better than many, the share market seems to be exposed to the parts of the economy that aren’t doing well.

As disappointment piles on disappointment and the years roll by it is no surprise investors are starting to give up and focus on preserving capital as opposed to seeking growth.

Given this, is the “stocks for the long term” approach still valid? Are long-term investors right to sit tight?

History is on the side of shares

It is well known that over very long periods of time shares have provided superior returns to most alternatives such as cash or bonds. This can be seen in the following chart, which shows that since 1900 Australian shares have returned nearly 12%pa compared to 6% for bonds and 4.8% for cash.

In fact, due to the power of compound interest, $1 invested in 1900 would have grown to $280,657 today if invested in shares compared to $688 if invested in bonds even though the return on shares was just less than double that on bonds.

The story is the same for the US, albeit not quite as impressive. Since 1900, US shares have returned 9.5% per annum compared to 4.5% per annum for bonds and 3.6% per annum for cash.

But, of course, no one has 110 years to invest over. And some might observe that the steepness of the lines for cash and bonds has increased since the 1970s relative to shares.

But investors don’t have 110 years?

Of course investors don’t have 110 years, so it may be argued that the previous chart is irrelevant.

This is not so.

The next three charts show the rolling annual returns over 10, 20 and 40 years ended at the dates shown in the horizontal axes. Over rolling 10-year periods, while shares have invariably done better, there have been periods in the 1930s/early 1940s and since the 1970s where returns from bonds and or cash have done better. And shares have only done marginally better than bonds over the last decade.

Pushing the horizon out to rolling 20-year returns has invariably seen shares do better than cash and bonds, although a surge in cash and bond returns from the 1970s/early 1980s has seen the gap narrow and there have been some years where returns over the prior 20 years have been better from bonds than shares. However, this has been the exception. Over the last 20 years shares have returned 8.8% per annum, versus 7.6% per annum from bonds and 5.7% per annum from cash.

Over rolling 40 year periods – representative of the working years of a typical person – share returns have been remarkably stable in a range around 12%. And while rolling returns from bonds and cash have picked up since the early 1980s, shares have always done better.

It can be seen that while shares don’t outperform cash and bonds over all 10-year periods they invariably have done so over 20-year periods and have always done so over 40-year periods. This is consistent with the basic proposition that the higher short term volatility and hence risk from shares (reflecting the exposure to periods of falling profits and a real risk that companies go bust) is rewarded over the long term (defined as beyond 10 years) with higher returns.