Stocks for the Long-run and Irrational Exuberance: Part 1

Thanks to retirement I have found time to read books. Some time ago I purchased a second-hand copy (2015 5th edition) of “Stocks for the Long Run” by Jeremy Siegel, Louise was puzzled by this. Driven by misplaced enthusiasm, I proceeded to tackle “Irrational Exuberance” by Robert Shiller. The two authors don’t always agree. So, who to believe? A respected academic and market commentator, or a Nobel prize-winner?

Let’s start with Mr Siegel. His proposition is “that stocks are indeed the best long-term investment for those who learn to weather their short-term volatility.”

So, what constitutes “best” in an investment context? Jeremy quotes legendary investor John Templeton as saying “For all long-term investors there is only one objective – maximum total return after taxes.” I would add after fees and feel risk deserves a mention. Quibbles aside, this definition seems reasonable. In addition, the book focuses on returns adjusted for inflation, or real returns. I agree real returns matter. For example, if you receive a 10% return when inflation averages 20%, your purchasing power is eroded.

While there is a nod to global markets the evidence presented is US centric. The thinking behind the proposition above is captured in his first two successful investing guidelines:

1.?????? “Keep your expectations in line with history. Historically stocks have returned between 6 and 7 percent after inflation over the last two centuries and have sold at an average P/E ratio of about 15.”

2.?????? “Stock returns are much more stable in the long run than in the short run. Over time stocks, in contrast to bonds, compensate investors for higher inflation. Therefore, as your investment horizon becomes longer, put a larger fraction of your assets in equities.”

Let’s examine the first of these guidelines.

I think most people are attracted to the concept that past long long-run returns are a useful, or even reliable, guide to future returns. I am not so sure.? Assuming the past will be repeated is an example of inductive reasoning. Often, we see the disclaimer on investment material that past returns are not a reliable guide to future returns. Generally, the disclaimer is aimed at short run results but is the disclaimer also applicable to long run returns? I will leave you to ponder that.

I still believe in investing in a well-diversified equity portfolio (‘equities’) for the long run. However, for the expected return component my reasoning is along the lines:

·???????? Equities are riskier than bonds (more on that another time)

·???????? Higher reward is expected for taking higher risk

·???????? Hence, while there will be periods of disappointment, I expect a higher return from equities than bonds

Another way of putting this is what do you have to believe to justify expecting equities to outperform bonds? You need believe equities are riskier than bonds and that higher risk comes with an expectation of higher return.

Next, I consider Jeremy Siegel’s second successful guideline relating to risk. The book presents evidence to support the intriguing finding that:

“Although standard deviation of stock returns is higher than for bond returns over short term holding periods, once the holding period increases to between 15 and 20 years, stocks become less risky than bonds.”

The book attributes this to a combination of mean aversion of equity returns and mean aversion (a term I have not heard of) bond returns. In addition, equities are considered to provide a better inflation hedge than bonds.

I am not entirely convinced by the mean reversion argument. Elsewhere in the book the following statement is made:

“But the risk and return on stocks and bonds are not physical constants, like the speed of light or gravitational force, waiting to be discovered in the natural world. Investors cannot, as in the physical science, run repeated controlled experiments, holding all other factors constant, and home in on the ‘true’ value of each variable.”

If this statement is correct (it resonates with me) and we don’t know what the ‘true’ mean equity return is, how can we be sure we are reverting to the mean? Also, if we don’t know what the mean is how can we be confident in the standard deviation around an unknown mean?

My take is there is a lot of random noise in short-term equity price movements (more on this when we examine Shiller’s “Irrational Exuberance”). There is an entire industry of intelligent investment professionals devoting a lot of time to explaining daily stock price movements, generally after the event. I believe this is a fruitless exercise.

Over the long-term I believe short term equity price fluctuations tend to cancel each other out. While I am unsure what the long run mean equity return will be, and if swings up and down are reverting to a mean, I agree with Mr Siegel’s idea that if you have say a 15-20 year horizon equity volatility is less concerning. Unfortunately, a lot of investors don’t have the patience or nerve to invest for 15-20 year periods.

In summary, I agree with Mr Siegel’s proposition “that stocks are indeed the best long-term investment for those who learn to weather their short-term volatility.” I reach the same end point from a different perspective. This is what makes grappling with investment concepts both fascinating and frustrating. Often there is not a right or wrong answer. While I am unsure what the long-run equity risk premium is I believe it exists. I think there is a relationship between investment risk and reward. Also, I think there is a lot of noise in equity prices which tends to cancel out over time.

Note: The above is intended to be a thought piece and does not purport to give investment advice.