Investing Demystified

by Lars Kroijer

  It is worth noting that various countries have greater or smaller stock markets relative to their national economies (see Figure 5.4). The US currently represents approximately 35% of world equity markets, but its share of the world GDP is only just over 20% (and declining). Some countries have a longer history of stock listings and perhaps a more favourable legal system for publicly quoted stocks. Likewise, because most companies today have significant operations abroad we should not expect the stock market valuation to be a precise reflection of the domestic economy. But whatever the reasons, as a world equity investor you should not expect your geographic exposure to exactly match that of economic output.

  Figure 5.3 World equity market value

  Based on data from www.worldbank.org

  Figure 5.4 Equity market value versus country GDP

  Based on data from www.worldbank.org and www.imf.org

  While I think it would be ideal if all countries had roughly similar GDP/market value ratios, as then the portfolio would be even better diversified, I think it is more important to be weighted in line with market values in a world index. If there are risk/return benefits from reallocating capital between markets we can trust the efficient markets to do so, and as a result trust our market value-based portfolio to be efficient.

  When you buy a world equity product you will naturally incur foreign exchange exposure as the majority of the underlying securities will be listed in a currency other than your own. For example, when you as a UK-based investor buy the sterling-denominated world equity index tracker you will indirectly be buying shares in the Brazilian oil company Petrobras. Petrobras is quoted in the Brazilian currency (the real (R)) so in order to buy the Petrobras shares, the product provider has to take the sterling amount and exchange it for reals, and then buy the stock (see Figure 5.5). Likewise with all the other currencies and securities represented in the index.2

  Figure 5.5 An example of stock and currency exposure

  In the example shown in Figure 5.5 you are now exposed both to the fluctuation in the share price of Petrobras and also movements in the GBP/Real exchange rate (see Figure 5.6 for an example).

  In this example, I assumed that the Petrobras share price went from R20 to R25 while the £/R rate went from 3.2 to 3.1. The aggregate impact of this on the portfolio was that the £100 investment went up in value to £129 because of the mix of share price appreciation and the £/R currency movement.

  The many different stocks and currency exposures in the world equity portfolio add further to the diversification benefits of the broad-based portfolio exposure. If your base/home currency devalued or performed poorly, the diversification of your currency exposure would serve to protect your downside.

  Some investment advisers argue that you should invest in assets in the same currency that you will eventually need the money in. So a UK investor should buy UK stocks, a Danish investor should buy Danish stocks, someone who eventually needs money in different currencies should buy a mix (if you have different costs in different currencies), etc. There is some merit in currency matching specific and perhaps shorter-term liabilities, but the matching is better done by purchasing government bonds in your home currency (the minimal risk asset). If you worry that major currencies fluctuate too much for you, I question whether you should be taking equity market risk in the first place.

  Figure 5.6 Combined impact of share price and currency movement

  The broader investment and currency exposure is favourable not only from a diversifying perspective, but also as protection against bad things happening in your home country. Historically, whenever a currency has been an outlier it has performed poorly because of problems in that country (there are exceptions to this rule of thumb), and it is exactly in those cases that the protection of a diversified geographic exposure is of the greatest benefit to you.3

  Expected returns: no promises, but expect 4–5% after inflation

  The return expectation from equity markets is driven by our view of the ‘equity risk premium’. The equity risk premium is a measure of how much extra the market expects to get paid for the additional risk associated with investing in equity markets over the minimal risk asset. This does not mean that stock markets will be particularly poor or attractive right now; it means that investors historically have demanded a premium for investing in risky equities, as opposed to less-riskier assets. We also assume that investors expect to be paid a similar premium for investing in equities over safe government bonds in future as they have historically.

  The size of the equity risk premium is subject to much debate, but numbers in the order of 4–5% are often quoted. If you study the returns of the world equity markets over the past 100 years (see Table 5.1) the annual compounding rate of return for this period is close to this range. Of course it is impossible to know if the markets over that period have been particularly attractive or poor for equityholders compared to what the future has in store.

  The equity risk premium is not a law of nature, but simply an expectation of future returns, in this case based on what those markets achieved in the past, including the significant drawdowns that occurred. Economists and finance experts disagree strongly on what you should expect from equity returns in future and some consider this kind of ‘projecting by looking in the rear-view mirror’ wrong. In my view, the long history and volatility of equity market returns gives a good idea of the kind of returns we can expect in future. Equity market investors have in the past demanded a 4–5% return premium for the risks that equity markets entail, and I think there is a good probability that investors in future are going to demand a similar kind of return premium for a similar kind of risk in the equity markets.

  Table 5.1 Returns 1900–2011 (%)

  Source: Credit Suisse Global Returns Handbook 2012

  A criticism of using historical returns to predict future returns is that this predicts higher returns at market peaks and lower returns at market lows.4 Historical returns looked a lot better on 1 July 2008 than on 1 July 2009 (after the crash), and perhaps because you were attracted by the high historical returns in mid–2008 this was exactly the time that you invested in equities. Combining high historical returns with low expected risk at the time made equity markets look very attractive at precisely the wrong moment.

  I understand why some criticise the expected return, but think that the length of data mitigates this. With hundreds of years of data across many countries (some have used only US data in the past, but that introduces selection bias by excluding markets that have performed poorly), incorporating great spectacular declines, great rises, and everything in between, I think historical data is the best guide to the kind of risk and return we can expect from equity markets in future.

  Practically speaking, investors have been unable to buy the whole world of equities for many years. One of the leading index providers, MSCI, only started tracking a ‘world index’ in late 1960s, but finding liquid products that actually followed this or similar indices did not start in earnest until decades after that. Figure 5.7 shows historical returns for the MSCI World Index since inception. In this case, I think the time horizon is too short (401 years) to use the data to make predictions about future world equity returns, when we have longer historical data sets (albeit not as an index done at the time).

  Figure 5.7 MSCI World index since inception (dividends reinvested)

  Lars’s predictions

  So, in simple terms, on average I expect to make a 4–5% return a year above the minimal risk rate5 in a broad-based world equity portfolio. This is not to suggest that I expect this return to materialise every year, but rather that if I had to make a guess on the compounding annual rate in future it would be 4–5% (see Table 5.2). Note that while the equity premium here is compared to short-term US bonds I would expect the same premium to other minimal risk currency government bonds because the real return expectation of short-term US government bonds is roughly similar to that of other AAA/AA countries like the UK, Germany, Japan, e
tc.

  Table 5.2 Expected future returns (including returns from dividends) (%)

  Real1 Risk2

  World equities 4.5–5.5 20.00

  Minimal risk asset 0.50

  Equity risk premium 4–5

  1After inflation.

  2See Chapter 6 for a discussion of issues with risk measures.

  For those who consider these expected returns disappointing, I’m sorry. Writing higher numbers in a book or spreadsheet won’t make it true. Some would even suggest that expecting equity markets to be as favourable in the future as in the past is wishful thinking. Besides, a 4–5% annual return premium to the minimal risk asset will quickly add up to a lot; you would expect to double your money in real terms roughly every 15 years!

  The power of compounding never ceases to amaze me. If I dropped my daily Starbucks visit and put the £4 daily savings into the equity markets at a 5% annual return I would have almost five times the current average national income in the UK in savings on the day I turned 70 (I am 40 now).

  Many of you may be uncomfortable with having important stock market expectations simply being based on something as unscientific as historical returns or my ‘guesstimate’ of that data. Perhaps so, but until someone comes up with a reliably better method of predicting stock market returns it’s the best we have and a very decent guide. Also, we know that the equity premium should be something – if there were no expected rewards from investing in the riskier equities we would simply keep our money in low-risk bonds.

  Another problem with simplistically predicting a stable risk premium is that we don’t change it in line with the world around us. It probably sits wrong with most investors that the expected returns in future should be the same in the relatively stable period preceding the 2008 crash as it was during the peak of panic and despair in October 2008. Did someone who contemplated investing in the market in the calm of 2006 really expect to be rewarded with the same return as someone who stepped into the mayhem of October 2008?

  Someone willing to step into the market at a moment of high panic would expect to be compensated for taking that extra risk, suggesting that the risk premium is not a constant number, but in some way dependent on the risk of the market. At a time of higher expected long-term risk, equity investors will be expecting higher long-term returns. The equity premium outlined above is an expected average based on an average level of risk.

  In summary

  In the interest of making something as complicated as the world financial markets into something almost provocatively simple, Figure 5.8 outlines where we are in terms of returns after inflation.

  As an investor who seeks returns in excess of the minimal risk return you can add a broad portfolio of world equities. You can reasonably expect to make a return of 4–5% a year above the rate of minimal risk government bonds, which we expect to be about 0.5% a year, although expect that return to vary significantly for a standard deviation (see Chapter 6) of about 20% a year.

  If the world equity markets are too risky for you, combine an investment in that with an investment in the minimal risk bonds to find your preferred level of risk. In brief:

  Or you can do any combination of the above that suits your individual circumstances.

  Figure 5.8 Where are we now?

  Figure 5.9 The simple rational portfolio

  Buy the broad equity exposure cheaply through index-tracking products. This is important. Later (in Chapter 14) I will discuss exactly which products you can buy to achieve the exposures above, subject to your tax circumstances.

  If you do as recommended in this chapter you will, over the long term, do better than the vast majority of investors who pay large fees needlessly and consequently get poorer investment returns. And keep in mind that this portfolio can be created by combining just two index-tracking securities; one tracking your minimal risk asset and one tracking the world equity markets. An excellent portfolio with just two securities (see Figure 5.9): who said investing is difficult?

  If this seems too simple, remember that the world equity exposure represents an underlying exposure to a large number of often well-known companies in many currencies all over the world. Your two securities thus get you a mix of amazing diversification along with a minimal risk security that gives you the greatest amount of security possible. How much you want of each depends on the risk/return profile you want.

  1 Some emerging market companies listed their shares on Western exchanges to increase credibility and foreign companies thus make up a meaningful part of some exchanges.

  2 The trading set-up may sound cumbersome and expensive, but major product providers naturally have off-setting flows that reduce trading, but are also set up to trade FX (foreign exchange) and stocks very cheaply, or have derivative exposures or sampling that can also reduce costs and keep things simple.

  3 Currency-hedged investment products do exist but in my view the ongoing hedging expense adds significant costs without clear benefits, and on occasion further fails to provide an accurate hedge. Besides, many companies have hedging programmes themselves, meaning that a market may already be partially protected against currency moves, or have natural hedges via ownership of assets or operations that trade in foreign currencies (like Petrobras owning oil that trades in US dollars).

  4 You can also estimate the equity risk premium by looking at the dividend yield of the stock markets, or the average price/earnings ratio. Combining either of these measures with longer-term earnings growth estimates could also yield an estimate of projected stock market returns. The problem as I see it with either of these measures is that both use quite short-term financial data and combine that with a highly unpredictable long-term growth rate to extrapolate something as uncertain as future stock market returns. Alternatively, some suggest using surveys asking investors what their projections for the market returns are. While interesting (different countries often have very different results) these surveys have been criticised for being heavily sentiment driven and more about a desired return than one actually expected.

  5 While the historical risk premium was calculated as a premium to short-term debt, the minimal risk asset return expectation of 0.5% is not as short-term (highly rated real short-term debt returns at the time of writing have negative yields). However, historically the short-term real return has been closer to 0.5% and this is what the equity risk premium is based on. Also, the current yield curve suggests that the negative real interest rate will not last forever.

  chapter 6

  * * *

  The risk of equity markets

  Understanding the risk you take to get returns

  It seems that every pre-bubble period is characterised by an abundance of changing paradigm stories or that ‘this time it’s different’, only for history to repeat itself and markets falling. What follows are the inevitable stories about people who saw it coming and those who predict further gloom.

  While nobody really knows what will happen to the stock markets, we can make some observations about the risks we take in investing in them. Figure 6.1 shows world and US equity market risk over the past 25 years, illustrated as the trailing 12-month standard deviation (SD) of the returns (explained below).

  What you immediately notice is that the risk moves around a lot – it won’t surprise you that the markets moved around a lot during the 2008–09 financial crisis (notice the spike in 2009 where the standard deviation was over 40% for world equities), while market returns were far less volatile in 2007, right before the crisis. What you also notice is how closely tied the world and US risks appear. This is not a surprise as the US market is the largest component of the world market, but also because the world is far more interconnected than it used to be. But what we can also see from Figure 6.1 is that expecting a standard deviation of the equity markets of 20% on the basis of how it has been in the past is not a terrible guess.1

  Figure 6.1 Risk of equity markets (trailing 12 months standard deviation)

  The standard d
eviation is important as it is meant to give you an idea of how much returns may vary. It assumes that returns are distributed around an expected average return of all the many potential outcomes, and the standard deviation tells you how different from the average return many outcomes will be. A higher standard deviation means that more outcomes are very different from the average outcome, while a low standard deviation suggests that most outcomes are clustered around the average outcome. While we don’t know what the future outcome will actually be (unless you have a crystal ball), the standard deviation helps us understand how great a variation there may be in actual future outcomes.

  The standard deviation

  Table 6.1 gives you an idea of how frequently you may lose a lot of money, depending on the risk you think equities will have. The higher the standard deviation the more frequently you will lose a lot of money.2 A 20% annual standard deviation for equity returns may be a reasonable guess in future, but as you can see from Figure 6.1, the standard deviation does vary a lot over time. Table 6.1 shows how much you would lose at standard deviations of between 1 and 3 (so increasingly unlikely and big losses), if the standard deviation of the markets was 15–35% and you assumed that the markets on average return 5%.

  Table 6.1 Losses according to standard deviation (SD)

  So while it is obvious that greater risk generally means more fluctuating outcomes, the standard deviation helps us quantify it. Instead of putting a finger in the air and making vague statements like ‘losing 20% in a year is pretty unlikely’, the standard deviation can help us be more specific if we have a view on how risky the market is. And greater specificity helps us understand the potential frequency of different losses when investing in the market.