March Tweets

13F Critics, Silenced?

I don’t hear nearly as much from the 13F critics anymore.  Maybe they have simply lost interest, or perhaps the real time performance of the 13F strategies have converted them into believers, who knows.  I’ve been sending out hedge fund profiles each Sunday to The Idea Farm with current holdings and backtests and investors seem to love the updates.

Covered so far:

APPALOOSA,  ARIEL, AVENIR, BARROW, BAUPOST, CHIEFTAIN & BRAVE WARRIOR

Upcoming:

COBALT, ESL/RBS, EMINENCE, FAIRHOLME, GARDNER RUSSO, GLENVIEW, GREENLIGHT, LSV, MARATHON, PAR, RELATIONAL, RUANE CARDIFF, SPO, THIRD POINT, VALUEACT, YACKTMAN, FUND GROUPS, COLLECTIVE INTELLIGENCE, & THE TIGER CUBS, JAT, PENNANT, SOUTHERN SUN, TETON, ABRAMS, 12WEST, ALTAI, ARLINGTON, MITTLEMAN, KINGDON, EAGLE, JERICHO, KERRISDALE, RAIFF, BRIDGER, JANA, IVORY, PABRAI

If you have any fund suggestions let me know!

I thought it would be fun to look back at the generic “World Beta” clone that I haven’t touched since AlphaClone launched many moons ago.  These are not the same funds I would pick today, but hey that’s not a bad list!  Top 5 positions from these funds would have beaten the market 6 of last 7 years in real time…If you pick the most popular amongst these funds the results are even better.

Appaloosa Management

Baupost Group

Berkshire Hathaway

Blue Ridge Capital

Eminence Capital

Greenlight Capital

Lone Pine Capital

Maverick Capital

Tiger Global Management

 

wb wb2

Stocks are the Most Expensive, Well, Ever

I jabber a lot about valuation metrics here, and I mentioned this one on Twitter the other day.  Its doesn’t need much explanation – the median stock in the S&P 500 is the most expensive it has even been (for as long as we have data).  That’s never a good sign!

If your favorite valuation indicator is not at “the highest ever” , many valuation indicators and now at “the highest ever except 2000″.  That’s not good company unless you are a short seller.

Click to enlarge…

Screen Shot 2015-03-11 at 10.31.38 AM

Copyright 2015 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved.

See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

What a Great Time To Be An Investor!

There has been a lot of press lately on the roboadvisors, largely due to the fact that Schwab entered the market this week with their Intelligent Portfolio service that charges a 0% management fee (but invests in their own ETFs).  If you haven’t been reading my blog since 2006, I have written many times on their development and in general I am very positive on the emergence of the robos (and the non-robos like Vanguard).  I even mentioned a handful of the automated investment services in my new book Global Asset Allocation.  There is a lot of misinformation so I thought I would make a few comments below.

I expect the large custodians like Schwab, Vanguard, and Fidelity to dominate this space eventually for a few reasons.  They have their own ETFs (a huge cost benefit), and they already have massive scale, distribution, and AUM (anything with a T is pretty big).  I likewise expect some of the big ETF shops (like Powershares, WisdomTree, or FirstTrust)  to enter the space on their own at some point in some capacity – allocation ETFs or a full robo offering.

Despite the fact I expect the big sponsors to dominate, that doesn’t mean there isn’t room for 5+ automated advisors. Maybe even 10.  After all the #5 ETF sponsor manages $50 billion and #30 manages $1 billion.  Could there be 30 robos managing over $1b?

Despite the big opportunity for all parties, Schwab and Wealthfront quickly got into a catfight over some various specifics of how they invest and operate.  (Wealthfront post here and Schwab’s response here Scott Bell’s comments here and Howard Lindzon’s here.)  It is weird and somewhat embarrassing they are fighting so much since they are really on the same side and it should be a rising tide for both.  So, in my mind they should be cheering each other on against the high fee crowd, but they’re not, which is a shame.  Their concerns were two main (minor in my mind) points in the asset allocation process:

Cash Allocation

Wealthfront took Schwab to task over their cash allocations in their portfolios.  I don’t mind cash as a strategic allocation, but I do agree with Wealthfront that Schwab earning revenues from the money market sweep accounts could bias their decision to include cash.  There is just no need to do this – they could have used their short term gov bond ETF at 8 bps and still made the same amount as their money market spread.  However, the moral outrage from Wealthfront comparing Schwab to Merrill is a little ridiculous considering Wealthfront used to charge 1.25% for access to “geniuses”.    I applaud that they have pivoted to the new low fee structure, but was it simply because the old business model didn’t work, or that all of a sudden they got religion on how they view the investment world and did a 180?

Smart Beta Allocation

Wealthfront also talked about how Schwab uses smart beta investments, and include two quotes that “smart beta products are not smart investments” and “smart beta is stupid”.  This is odd since Wealthfront itself does not track the global portfolio and likewise uses smart beta funds like dividend/value.  They go as far to state that dividend stocks can be a bond substitute (which is crazy).  I applaud Schwab for using smart beta funds – after all almost anything outperforms the market cap weighted portfolio.

So, I agree with Wealthfront on the cash issue and agree with Schwab on the smart beta issue.  But again, to me it isn’t really the point – I think they should be cheering each other on.  The irony is that the roboadvisors can debate endlessly about their allocations and which is superior, but in reality their asset allocations will likely be very similar and perform similarly as well.  Our new book demonstrates that almost all allocations cluster quite closely, and the backtested returns of Wealthfront and Betterment are likewise pretty darn close. 

So if the asset allocation is a commodity, then you should pay as little as possible for that.  Lost in the debate is that there has never been a better time to be in control of your own investments and both offerings are killer.  The competition between roboadvisors will create downward pressure on fees that will massively benefit the end investor.

We forget that the average mutual fund charges 1.25% and the average advisor 1.0%.  The top quintile charges over 2% for both!!  While Schwab and Wealthfront argue over basis points, there are shops that still manage many billions like The Mutual Fund Store, Edelman, and Fidelity Portfolio Advisory that charge over 1.5%…And not too long ago we lived in a world that was much, much more expensive than even that.  Remember front-end loads and 12b-1 fees? They still exist.

And while most roboadvisors are solid on the fee front, there is an even better choice.  A 0% management fee ETF is superior to all of the roboadvisors for three or perhaps four reasons.  (There is only one of those in existence currently but I expect someone to copy our model within the next 6-12 months.)  Below is why:

1.  The ETF at 0.29% likely has the lowest total expense ratio versus the roboadvisors (Schwab is potentially the only competitor but not if you add in cash revenue from the money market sweep).

2. The ETF has superior tax treatment to the roboadisors.  Both can tax harvest, but the ETF structure is unique in that it benefits from the creation/redemption structure.

3.  The ETF can engage in short lending, and return all of the revenue to the fund.  Vanguard does this and effectively offers ETFs that are expense ratio negative, meaning they pay you to own them.  Think about that for a second – you are getting paid to own an ETF!  Could the robos eventually do short lending?  Maybe, but it is operationally challenging and not sure this works across separate accounts. (But they should look into it.)

4.  You can track the audited exchange traded performance of the ETF, whereas none of the roboadvisors are GIPS certified or audited (to my knowledge).  It is near impossible to find published performance since inception. (Again, they should look into it.)

I still think any of these automated options (asset allocation ETFs or robos) are great choices for the buy and hold crowd.  Frankly the fees will be rounding errors compared to any of the behavioral mistakes people make.   (Tactical is another solution but not the point of the post.  Those that know me also know I am a trendfollower at heart, and publish my portfolio every year.)

Assuming you now have the allocation put to bed, what is the big value add of a roboadvisor outside of that? The argument starts to break down, especially when we get another big fat bear and you want someone to talk to.

And that is where the advisor comes in, and there are many thousands of great traditional advisors to choose from around the US.  As far as online ones, only two major players come to mind and those are Vanguard  (0.3%) and Personal Capital (closer to .9% in fees).  Either the roboadvisors or low/no fee asset allocation ETFs allow advisors (and investors) to be freed up to do what they do best – service the client and not worry about the asset allocation.  So an investor (individual or pro) can allocate to a core, 0% management fee ETF and move on to more important things.

In summary:

1.  It is a a great time to be an investor!

2.  The emergence of the roboadvisors and low cost cyberadvisors (advisor powered automated solutions like Vanguard) are a huge positive for investors and advisors alike.

3.  While the roboadvisors scrap over basis points, they should be on the same side and focus their energy on the high fee competition.

4.  Despite the positive benefits of a roboadvisor, they can’t compete with an asset allocation ETF.

5.  Investors, and advisors can focus their attention on more important things now that a buy and hold allocation is a commodity.  Go live and enjoy your life!

CHAPTER 3 – ASSET CLASS BUILDING BLOCKS

This excerpt is from the book Global Asset Allocation now available on Amazon as an eBook.   If you promise to write a review, go here and I’ll send you a free copy. It is also available as a printable PDF on Gumroad.

—-

“I think the single most important thing that you can do is diversify your portfolio.”

–Paul Tudor Jones, Founder Tudor Investment Corporation

The next two questions and answers will likely surprise you.

Question 1 – Quick, what is the world’s largest financial asset class?  Don’t know?

Answer: Foreign ex-U.S. bonds!  This is usually surprising to most investors who assume the answer is U.S. stocks or bonds.

FIGURE 15 – The Largest Asset Class in the World

15

Source: Vanguard

 

Question 2:  How much of your global stock allocation should be in the United States?

Answer: About half!

 

U.S. investors usually put around 70% of their stock allocation at home here in the U.S.  This is called the “home country bias”, and it occurs everywhere.  Most investors around the world invest most of their assets in their own markets.  Figure 16 is a chart from Vanguard that details the “home country bias” effect in the U.S., the U.K., Australia, and Canada.  The blue bars are how much investors should own of each country according to global weightings, and the red bars are how much they actually own of their own country – way too much!

FIGURE 16 – Home Country Bias

16

Source: Vanguard

 

Figure 17 is a chart from the Credit Suisse GIRY update we mentioned earlier.  It details the U.S. as a percentage of world market capitalization (52%) in 2014.  Given this, while most of us here in the United States invest 70% of our stock allocation in U.S. stocks, in order to be truly representative of the global marketplace  it really should only be about half.   Note that the U.S. was only 15% of world market cap back in 1899.  As a share of global GDP, the U.S. is only 20% (emerging markets are 50% of global GDP, but only 13% of market capitalization).

 

 

 

FIGURE 17 – Stock Market Sizes, 1899 and 2014

 17

 

Source: Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press 2002, Credit Suisse Global Investment Returns Sourcebook 2015

 

The point of the two questions at the beginning of the chapter is that we live in a global world.  There is no need to build an investment portfolio with just exposure to U.S. stocks and bonds.  Figure 18 is another chart of how market cap weightings have changed over time.  Notice the large Japanese bubble expansion in the 1980s and the rapid contraction afterward.

 

 

FIGURE 18 – Stock Market Sizes, 1900 to 2012

18

Source: Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press 2002, Credit Suisse Global Investment Returns Sourcebook

 

The key question for investors to ask, then, is, “What would our allocation look like if we expanded the 60/40 portfolio to include foreign stocks and bonds? Would that help improve our returns or reduce our risk?”

 

The Global 60-40 Portfolio

The next portfolio we will examine is the 60/40 portfolio, only now we are using global indices rather than just U.S. ones.  We split the stock allocation into half domestic and half foreign developed stocks (MSCI EAFE), and split the bond allocation into half domestic and half foreign 10-year government bonds.

Going global in this illustration doesn’t change the end result too much, though it does increase returns, reduce volatility, and improve the Sharpe ratio (all good things).  The global portfolio also did better during the inflationary 1973-1981 period, as Figure 19 shows.

 

FIGURE 19 – Various Assets and Strategies, Real Returns, 1973-2013

19

Source: Global Financial Data

 

20

 

 

Source: Global Financial Data

 

There is no reason, however for investors to focus exclusively on stocks and bonds.  Would increasing amounts of granularity with additional asset classes help when looking at building a diversified portfolio?  In this book, we are going to examine 13 assets and their returns since 1973. They are found in Figure 20 below with a column denoting what broad category of assets they fall under.

 

FIGURE 20 – Asset Classes

21

Are there other asset classes? Of course.  However, many asset classes (or sub-asset classes) do not have sufficient histories to analyze, such as emerging market bonds.  For those unfamiliar, REITS are publicly traded real estate investment trusts, and TIPS are U.S. Treasury inflation protected bonds.

We also exclude active approaches to investing even though we discuss some of these “tilts” in other white papers and books like Shareholder Yield.  So while an active strategy like managed futures is one of my favorite investment strategies, we don’t include it in the building blocks section.  (I like to call trendfollowing my “desert island” strategy if I had to pick one method to manage money for the rest of my life.  While not the topic of this book, we have written a great deal about trend strategies on the blog as well as in the white paper “A Quantitative Approach to Tactical Asset Allocation.”)

Figure 21 presents a chart of the asset classes we examine in the following chapters.

 

 

FIGURE 21 – Various Assets, Real Returns, 1973-2013

real 21

Source: Global Financial Data

We didn’t label the asset classes in the chart on purpose simply to demonstrate that while the indexes traveled different routes from start to finish, all of the asset classes finished with positive real returns over the time period. The fact that bonds were even close in absolute performance to the other equity-like asset classes reflects the greater than thirty-year bull market that took yields from double-digit levels to near 2% today. The below charts demonstrate the returns and risk characteristics of the various asset classes.

FIGURE 22 – Asset Class Nominal Returns, 1973-2013

22

3

2

Source: Global Financial Data

 

While these are some pretty nice returns for these asset classes historically, they suffered through some large drawdowns.

Like we discussed before, nominal returns are illusory. You can’t spend or eat nominal returns.  Below in Figure 23 are the same building blocks but with real returns.  Stocks were in the ballpark of 5-7%, bonds 0-5%, and real assets 3-5%.  (Corporate bonds share equity-like characteristics, so we characterize them as 50% stocks and 50% bonds for purposes later in the paper.)

FIGURE 23 – Asset Class Real Returns, 1973-2013

a

c

b

 

 

Source: Global Financial Data

 

If an investor were to take the data back further, or use daily data observations, those drawdowns only get bigger. It is a sad fact that as an investor, you are either at an all-time high with your portfolio or in a drawdown – there is no middle ground – and the largest absolute drawdown will always be in your future as the number can only grow larger. (Unless you went bankrupt of course as then the amount is a total loss.  Sadly, Brazil’s richest man experienced this event when he lost over $30 billion – here is a good article on the topic with lots of lessons for individuals as well.)

One of the biggest challenges of investing is that any asset can have a long period of underperformance relative to other assets – or even outright negative returns and losses.  Cliff Asness, co-founder of AQR Capital Management, has a fun piece out on his blog titled “Efficient Frontier “Theory” for the Long Run”, where he talks about five-year periods in stocks, bonds, and commodities and basically how anything can happen over short periods of time. (Although for many investors, five years can feel like a lifetime.)

Using the data in Figure 24, we examine returns during two periods, inflationary 1973-1981 and falling inflation/disinflation 1982-2013.  We also look at asset returns by decade.  The final line in the table is the volatility of decade returns.  While there are only five observations its helps to demonstrate the decade level consistency.

What can we learn from these tables?  All of our assets had positive real returns, which is what you want from investing in any asset.

Real returns were much harder to come by in the inflationary 1970s.  Eight out of 13 asset classes had negative real returns in the 1970s.  Gold, commodities, and emerging market stocks had the best performance.  Everything was up big in the 1982-2013 timeframe, but gold and cash lagged the most as the transition from high interest rates and inflation led to growth, lower inflation, and lower still interest rates.  The only asset classes that had positive performance in every decade were emerging markets and TIPS, although the TIPS category is not a completely fair comparison since they were only introduced in 1997 and therefore this is a synthetic series that investors could not have allocated to at the time.

FIGURE 24 – Asset Class Returns, 1973-2013

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Source: Global Financial Data

While there are certainly hundreds of different portfolios one can construct from our 13 assets, we are going to focus on just a handful of allocations below. (More “lazy portfolio” ideas here.)

These allocations have been proposed by some of the most famous money managers in the world, collectively managing hundreds of billions of dollars.  We included a few other portfolios worthy of mention in the Appendix, but excluded them from the body of the text to keep things simple. Otherwise this book could have easily been 300 pages and the goal is not to put you to sleep but rather let you finish in one sitting and get on with your life.

The flow of the chapters will range from the portfolios that allocate the most to bonds to the ones that allocate the least.

Let’s get started!

CHAPTER 2 – THE BENCHMARK PORTFOLIO: 60/40

This excerpt is from the book Global Asset Allocation now available on Amazon as an eBook.   If you promise to write a review, go here and I’ll send you a free copy. It is also available as a printable PDF on Gumroad.

——

“No strategy is so good that it can’t have a bad year or more.  You’ve got to guess at worst cases: No model will tell you that. My rule of thumb is double the worst that you have ever seen.” – Cliff Asness , Co-founder AQR Capital Management

The most venerable asset allocation model is the traditional 60/40 portfolio.  The portfolio simply invests 60% in stocks (S&P 500) and 40% in 10-year U.S. government bonds.  We will use this portfolio as the benchmark to compare all of the following portfolios in this book.

The reason many people will invest in both stocks and bonds is that they are often non-correlated, meaning, stocks often zig while bonds zag. While the relationship isn’t constant, combining two or more non-correlated assets into a portfolio results in a better portfolio than just either alone.

How has this portfolio performed?  Let’s look at the U.S. 60/40 portfolio back to 1913, rebalanced monthly. We consider volatility to be measured by the standard deviation of monthly returns.  The Sharpe ratio is a measure of risk adjusted returns, and is calculated as:  (returns – risk free rate)/volatility.  The risk-free rate is simply the return of Treasury bills.  A higher Sharpe ratio is better, and a good rule of thumb is that risky asset classes have Sharpe ratios that cluster around the 0.20 to 0.30 range.

FIGURE 11 –Asset Class Real Returns, 1913-2013

11

Source: Global Financial Data

 

So it looks like you get a nice diversification benefit of investing your portfolio in both assets.  While 60/40 doesn’t quite achieve the returns of stocks, you reduce your drawdown a bit due to the assets not being perfectly correlated.   Figure 12 shows the equity curve of the strategy.

 

 FIGURE 12 –Asset Class Real Returns, 1913-2013

12

Source: Global Financial Data

 

One challenge for investors is how much time they spend in drawdowns.  It is emotionally challenging, largely, since we anchor to the highest value a portfolio has attained.  For example, if your account hit $100,000 last month up from $20,000 twenty years ago, you likely think of your wealth in terms of the recent value and not the original $20,000.  If it then declines to $80,000, most will think in terms of losing $20,000 rather than the long-term gain of $60,000.  The 60/40 allocation only spends about 22% of the time at new highs, and the other 78% in some degree of drawdown.  Drawdowns are physically painful, and the behavioral research demonstrates that people hate losing money much more than the joy of similar gains.  To be a good (read: patient) investor you need to be able to sit through the dry spells.

So why not just allocate to the 60/40 portfolio and avoid reading the rest of this book?

While 60/40 is a solid first step, we posit that focusing solely on U.S. stocks and bonds is a mistake.  In fact, this 60/40 approach presents a particularly difficult challenge to investors at the end of 2014, as we detail below.

U.S. stocks have returned a meager 4.9% per year from 2000 – 2014 and, factoring in inflation, have returned 1.90% per year, provided investors had the ability to sit through two gut-wrenching bear markets with declines of over 45%. According to recent DALBAR studies, many have not.  1.9% per year is a far cry from the historical 6.47% that U.S. stocks have returned over the full period from 1900-2014.

One of the reasons for the subpar returns is simple – valuations matter. The price you pay influences your rate of return. Pay a below average price and you can reasonably expect an above average return, and vice versa.  Valuations started the 2000s at extreme levels. The ten-year cyclically adjusted price-to-earnings (CAPE) ratio for U.S. stocks reached a level of 45 in December 1999, the highest level ever recorded in the U.S., as Figure 13 shows. (For those unfamiliar with valuation methods for stocks, we examine over 40 global stock markets and how to use global valuation metrics in our book Global Value.) This high starting valuation set the stage for very poor returns going forward for investors buying stocks in the late 1990s.

 Figure 13 – Ten-Year Cyclically Adjusted Price-to-Earnings Ratio (CAPE), 1881- 2014

13

Source: Shiller

 

As you can see in the Figure 14, future returns are highly dependent on those starting valuations. The current reading as of December 2014 is 27, which is about 60% above the long-term average of around 16.5. At the current levels over 25, future median ten-year returns have been an uninspiring 3.5% nominal and 1.00% real since 1900. Not horrific and not quite yet in a bubble—but not that exciting either. Once CAPE ratios rise above 30, forecasted future median real returns are negative for the following ten years – it doesn’t make sense to overpay for stocks!

 

Figure 14 – Ten-Year CAPE Ratio vs. Future Returns, 1900-2014

14

Source: Shiller

U.S. 10-year government bonds, on the other hand, have proven to be a wonderful place to invest during the past 15 years. The compound return was 6.24% and a nice 3.82% after inflation. The problem here, however, is that these wonderful recent returns come at the expense of future returns as yields have declined from around 6% in 2000 to near all-time low levels in the U.S., currently around 2%.

Future bond returns are fairly easy to forecast – each future bond return is simply the starting yield. Currently, your ten-year nominal return for buying U.S. government bonds will be around 2.25% if held to maturity.

So investors are presented with the following opportunity set of annual returns for the next ten years (assuming 2.25% inflation going forward, rounding to make it simple):

  • S. Stocks: 3.50% nominal, ~1% real
  • S. Bonds: 2.25% nominal, ~0% real
  • Cash/T-bills: 0.00% nominal, -2% real

That leaves a 60/40 investor with a 2-3% nominal return no matter which way you slice it, or about a 0-1% real return. Not exactly breathtaking! Many investors expect 8% (or even 10% returns) per year when, in reality, expectations should be ratcheted down to more reasonable levels.

Other highly respected research shops forecast similar bleak returns for U.S. stocks and bonds.  You can find more info at AQR, Bridgewater, Research Affiliates, and GMO.

So where should investors look for returns while minimizing their risk of overpaying? In the coming pages, we examine the benefits of expanding a traditional 60/40 allocation into a more global allocation with an additional focus on real assets as well.

February Tweets

Cash Cows of the Dow

I’ve been writing for a long time as to why a shareholder yield approach is better than a simple dividend approach.  (Here’s an old 2007 post.) Below we take a look at the 30 stocks in the Dow for a simple example.

Dividend yields on the group range from 0.7% to 5.4%, with the “Dogs” (top 10) averaging 3.7%.  Tack on their buyback yield and you end up with an average shareholder yield for the entire Dow of 5.5%.

However, if you instead sort on shareholder yield (here just dividends and net buybacks), you end up with a dividend yield of 2.7%, but a total shareholder yield of 8.13%.  I would rather have the latter portfolio, wouldn’t you?

Full chart below courtesy of YCharts, which I forgot I had a subscription to.  Nice site though.  Click to zoom in.

cows

Clipboard02

Webinar and NYC Travel

Tune in tomorrow and come ask some questions! Free webinar with my friends at S&P Dow.

 

I’ll be in NYC twice in March to speak at QuantCon on March 14th and the MTA Conference on March 27th.  If you want to schedule a meeting let me know!

 

CHAPTER 1 – A HISTORY OF STOCKS, BONDS, AND BILLS

This excerpt is from the book Global Asset Allocation now available on Amazon as an eBook.   If you promise to write a review, go here and I’ll send you a free copy. It is also available as a printable PDF on Gumroad.  To celebrate the launch of the new book, my last two ebooks (Global Value and Shareholder Yield) are free on Amazon for five days ending March 6th …

——

Let’s start with a history lesson.  Many people begin investing their money without a true understanding of what has happened in the past, and often bias their expectations toward their own personal experiences.  My mother always told me the way to invest was to buy some stocks and then just hold on to them.  But her experience, living in the United States and investing particularly in the 1980s and 1990s, was very different from her parent’s generation, which lived through the Great Depression.  Both of these experiences would be vastly different from those of the average Japanese, German, or Russian investor.

So what is possible and reasonable to expect from history?  We should begin with a discussion about the value of money.

A few years ago, my father and I were talking and he decided to demonstrate a real world example of inflation.  A couple weeks later, I received a letter with a check inside written by my great grandfather in the 1910s for $0.50.  He was a farmer who immigrated from Les Martigny-Baines, Voges France and ended up in Nebraska.  That $0.50 is equivalent to about $13 today and shows a very simple example of inflation.  As a side note, look at that penmanship!

 

FIGURE 1 – Real World Inflation

1

Source: Faber

 

A more familiar example is the oft-used phrase, “I remember when a Coca-Cola cost ten cents.” (Another fun example is “Superhero Inflation.”) Inflation is an emotional topic.  It usually goes hand-in-hand with a discussion of The Federal Reserve, and there are not many topics that incite more vitriol in certain economic and political precincts than “The Fed” and the U.S. dollar.

One of the most famous charts in all of investing literature is the one below that illustrates the U.S. dollar’s purchasing power since the creation of The Federal Reserve in 1913.  The description usually goes along the lines of this ZeroHedge post:

“This is the chart they don’t want you to see: the purchasing power of the dollar over the past 76 years has declined by 94%. And based on current monetary and fiscal policy, we have at least another 94% to go. The only question is whether this will be achieved in 76 months this time.”

The above statement is factually true – $1.00 in 1913 is only worth about three cents in current dollars due to the effects of inflation (which have averaged about 3.2% a year).  But that is all the chart tells you – the U.S. has had mild inflation this century (with fits of disinflation, deflation, and high inflation mixed in):

 

FIGURE 2 – U.S. Dollar Purchasing Power, 1913-2014

2

Source: Global Financial Data, Shiller

 

The chart is then used to justify any number of arguments and conclusions, usually laden with exclamation points!!!, bold text, and CAPITALIZATIONS.  Cries to end the Fed, buy gold, sell stocks, and build forts stocked with guns, food, and ammunition usually follow in a stream of rants and raves. These articles are written like this for a reason.  They elicit an emotional response (who doesn’t enjoy grumbling about the government?) and they certainly make for great headlines.

The problem that most miss is that investors have to do something with those dollars. Pretend you were an investor in 1913.  You could choose to put your dollars under a mattress, in which case your purchasing power would decline as indicated in the chart above.  You could also spend the money on consumption, such as vacations, entertainment, clothes, or food.  Or you could invest in Treasury bills, in which case the dollar was a perfectly fine store of value, and your $1 would be worth $1.33 today (for a real return of about 0.26% per year).

So you didn’t really make any money, but you were not losing any either.

Note that “real returns” refer to the returns an investor receives after inflation.  If an investment returned 10% (what we call nominal returns) but there was inflation of 2% that year, the real return is only 8%. Real returns are a very important concept as they make comparisons across timeframes more relevant.  A 10% return with 8% inflation (2% real) is very different than a 10% return with 2% inflation (8% real). It is helpful to think about real returns as “returns you can eat.”  That $1 Coke likely costs about the same as the $0.10 Coke, you are just paying with inflated dollars (and probably getting corn syrup instead of real sugar).

If you had decided to take on a little more risk, you could have invested in longer duration bonds, corporate bonds, gold, stocks, housing, or even wine and art—all of which would have been better stores of value than your mattress.

Figure 3 shows the real returns of stocks, bonds, and bills.  While $1 would be worth only three cents had you put your hard-earned cash under the mattress, it would be worth $1.33 had you invested in T-bills, worth $5.68 in 10-Year Treasury bonds, and worth a whopping $492 in U.S. stocks.

 

FIGURE 3 – Purchasing Power, 1913-2014

tb

Source: Global Financial Data, Shiller

 

For those looking for a beautiful coffee table book on the topic of historical market returns, check out my all-time favorite investing book, Triumph of the Optimists: 101 Years of Global Investment Returns. (There are also free yearly updates of the book from Credit Suisse here.  All of the yearly updates are highly recommended.)  This fantastic book illustrates that many global asset classes in the twentieth century produced nice gains in wealth for individuals who bought and held those assets for generation-long holding periods.  It also shows how the assets went through regular and painful drawdowns like the Global Financial Crisis of 2008.

Unfortunately for investors, there are only two states for your portfolio – all-time highs and drawdowns.  Drawdowns for those unfamiliar are simply the peak to trough loss you are experiencing in an investment.  So if you bought an investment at 100 and it declines to 75, you are in a 25% drawdown.  If it then rises to 110, your drawdown is then 0 (all-time high).

For some long-term perspective, set forth below are some charts based on data from the book Triumph of the Optimists (available through Morningstar as the Dimson, Marsh, and Staunton module but requires a subscription).  They represent the best-, middle-, and worst-case scenarios for the main asset classes of sixteen countries from 1900-2014. They have since updated their database to include 23 countries with results in the Credit Suisse reference link above.  All return series are local real returns and displayed as a log graph (except the last one).   U.S. dollar based returns are near identical.

First, here are the best-, middle-, and worst-cases for returns on your cash.

Figure 4 shows that leaving cash under your mattress is a slow bleed for a portfolio. Germany is excluded after the first series as it dominates the worst-case scenarios (in this case, hyperinflation).   Inflation is a major drag on returns. When it gets out of control, it can completely wipe out your cash and bond savings. So you mattress stuffers – on average you would have lost about 4% a year by keeping your money at home.

 

FIGURE 4 – Cash Real Returns, 1900-2014

Best-Case: -2.2% per year

Middle: -3.9%

Worst-Case: -100%

4

Source: Morningstar, Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, Credit Suisse Global Investment Returns Sourcebook 2015

 

Next up are real returns for short-term government bills. These instruments do all they can just to keep up with inflation.  You’re not usually going to make any money, as Figure 5 shows, but at least they don’t lose 4% a year like the mattress does. We also include the “World” which is the global market capitalization weighted portfolio which weights the portfolio based on size of each country’s stock market.

 

FIGURE 5 –Short-term Government Bills Real Returns, 1900-2014  

Best-Case: 2.1% per year

Middle: 0. 7%

Worst-Case: -3.5%
(Real Worst-Case, Germany -100%)

World:  0.9%

5

Source: Morningstar, Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, Credit Suisse Global Investment Returns Sourcebook 2015

 

In Figure 6, adding a little duration risk doubles the historical returns of bills for our 10-year bonds, but that is still a pretty small return.  You’re not going to get rich with 1.7% real returns, and you still have to sit through a 50% drawdown, as we will show later.

 

FIGURE 6 –Long-term Government Bonds Real Returns, 1900-2014

Best-Case: 3.3% per year

Middle: 1.7%

Worst-Case: -1.4%
(Real Worst-Case, Germany -100%)

World: 1.9%

6

Source: Morningstar,  Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, Credit Suisse Global Investment Returns Sourcebook 2015

 

And finally, we have the real returns for stocks.  Much better! Over 4% real returns per year is far superior to returns of the bond market.  While these are great returns, realize that it would still take over 15 years to double your money!

 

FIGURE 7 –Stocks Real Returns, 1900-2014

Best-Case: 7.4% per year

Middle: 4.8%

Worst-Case: 1.9%

(Real Worst-Case, China, Russia -100%)

World: 5.2%

7a

Source: Morningstar,  Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, Credit Suisse Global Investment Returns Sourcebook 2015

 

And in Figure 7a, the same chart is presented with a non-log y-axis.  We do this to demonstrate to readers the importance of viewing charts that have percentage changes over long time frames with a log axis.  Otherwise the chart is almost unreadable and definitely not useful.  Perhaps importantly, you can now distinguish between unscrupulous money managers advertising their services with the below style of chart which can be misleading, as the gains look much more dramatic.

 

FIGURE 7a–Stocks Real Returns, 1900-2014, Non-log Axis

7b

Source: Morningstar,  Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, Credit Suisse Global Investment Returns Sourcebook 2015

 

Let’s look at the entire series across all countries to visualize some of the best and worst-case scenarios.  It looks like a simple conservative rule of thumb may be to expect stocks to return around 4% to 5%, bonds 1% to 2%, and bills basically zero.  Note that the United States had one of the best performing equity and bond markets for the 20th Century.

 

FIGURE 8–Asset Class Real Returns, 1900-2014

8

Source: Morningstar,  Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press 2002, Credit Suisse Global Investment Returns Sourcebook 2015

 

One would think that the math above would make the decision easy – just put all your money in stocks!  While stocks outperformed the returns of bonds and bills, stocks are not without their own risks.  At least two countries had their equity markets wiped out when the government shut down the capital markets.  No wonder people are so wary of investing in Russia and China even today.

Another risk is that stocks can go for a really long time underperforming other asset classes, such as bonds.  It is easy to look at the data and assume you can wait out any stock market underperformance—at least until it happens to you.

In his 2011 “The Biggest Urban Legend in Finance,” Rob Arnott discusses a 30-year underperformance of stocks vs. bonds:

“A 30-year stock market excess return of approximately zero is a huge disappointment to the legions of “stocks at any price” long-term investors. But it’s not the first extended drought. From 1803 to 1857, U.S. equities struggled; the stock investor would have received a third of the ending wealth of the bond investor. Stocks managed to break even only in 1871. Most observers would be shocked to learn there was ever a 68-year stretch of stock market underperformance. After a 72-year bull market from 1857 through 1929, another dry spell ensued. From 1929 through 1949, stocks failed to match bonds, the only long-term shortfall in the Ibbotson time sample. Perhaps it was the extraordinary period of history—The Great Depression and World War II—and the spectacular aftermath from 1950–1999, that lulled recent investors into a false sense of security regarding long-term equity performance.”

A 68-year long stock underperformance is almost the same as a human’s current expected lifespan in the U.S.  Bonds outperformed stocks over an entire lifetime (really, more than a lifetime, since life expectancy in the 1800s was around 40 years in the U.S.).  When talking about stocks for the long run, then, it must mean something other than a human lifetime.  For a tortoise, deep sea tubeworm, or sequoia tree perhaps?  To be fair, the longer you go back in history the more suspect the data is, so we confine our analysis below to the post 1900 period.

Other countries experienced large drawdowns, and even in the United States, an investor lost about 80% from the peak in the 1929-1930s stock bear market.  The unfortunate mathematics of a 75% decline requires an investor to realize a 300% gain just to get back to even – the equivalent of compounding at 4.8% for 30 years! Even a smaller 50% drawdown would require 15 years at that rate of return to get back to even.

Large drawdowns are why many people choose to invest in bonds, but bonds are risky too.  While stocks typically suffer from sharper price declines, bonds often have their value eroded by inflation.  The U.S. and the U.K. have both seen real bond drawdowns of over 60%. While that sounds painful, in many other countries (Japan, Germany, Italy, and France), it was worse than 80%.  Some countries that faced hyperinflation resulted in a total loss, and Business Insider has a slideshow that examines a few of the worst examples in the past 100 years.

Figure 9 shows that both stocks and bonds have had multiple large drawdowns over the years.  The first chart uses monthly data (we don’t have monthly for the U.K.), and monthly data only increases the drawdown figure.

 

FIGURE 9 –Asset Class Real Drawdowns, 1900-2014

 9

Source: Morningstar, Bloomberg, Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press 2002

 

The same principle occurs in the U.K., but bond investors had to wait even longer to get back to even – almost 50 years!  Below is Figure 10 looking at yearly real returns and drawdowns.

 

FIGURE 10 –Asset Class Real Drawdowns, 1900-2014

10

Source: Morningstar, Bloomberg, Elroy Dimson, Paul Marsh, Mike Staunton, Triumph of the Optimists, Princeton University Press 2002

 

This is one of the problems with investing in just one security, country, or asset class.  Normal market returns are extreme.  Individuals invested in various assets at specific periods—U.S. stocks in the late 1920s and early 1930s, German asset classes in the 1910s and 1940s, Russian stocks in 1917, Chinese stocks in 1949, U.S. real estate in the mid-1950s, Japanese stocks in the 1990s, emerging markets and commodities in the late 1990s, and nearly everything in 2008— would reason that holding these assets was a decidedly unwise course of action. Most individuals do not have a sufficiently long time to recover from large drawdowns from any one risky asset class.

So what is an investor to do?  The next step lies in what is called the only free lunch in investing – diversification.

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