A timeless investment strategy: what can 400 years of historical data reveal?

Whether you're a seasoned investor or just starting out, this journey through four centuries of financial history will transform your perspective on investing.

Have you ever wondered how the great investment masters determine their strategies? The secret might just lie in understanding and applying lessons from the past.

In this article, we delve into the rich history of investing. Though seldom discussed, this subject could hold the key to a successful investment strategy.

his method for determining stock returns is straightforward and surprisingly effective, making it suitable for both the seasoned investor and those just starting out.

My mission is to prove that ignoring 400 years of historical investment data not only means missing out on opportunities but also significantly raises risks.

With the aim of crafting a robust strategy that stands firm in the most diverse economic conditions, we'll embark on an exploration of the investment world as it has unfolded over four centuries.

Are you ready to challenge your current strategy and learn from the age-old wisdom of historical financial data? Let's dive together into a world of opportunities that this timeless approach to investing can unlock.

A dive into financial history.

According to a thorough analysis by Global Financial Data (GFD), the average annual return on stocks from developed countries between 1601 and 2023 was about 7%. This is 100% higher than the average annual return on bonds, and it also surpasses virtually every other investment category.

My favorite article on stock and bond returns can be found [here ]. What's intriguing is that geopolitical events, inflation, and other economic factors matter very little in the extremely long run. This GFD blog post also details how returns over the past several centuries have been studied.

This average annual return of 7% means, due to the compound interest effect, your investment could potentially double every ten years.

This is the beauty of exponential growth. In the second year, not only is your first year's principal invested, but also the profit from year one. After 10 years, the average return isn't just 70% (10*7) but 100% (1.07^10).

A 100% return every 10 years is a very impressive return. However, let's not forget that stock markets rarely follow a linear growth pattern; ups and downs are the norm.

Stocks are volatile

In my personal investment journey, I've firsthand experienced the volatile nature of stocks from the developed world. As the MSCI World is accessible to everyone for free, I use this index as a proxy for equities from wealthy countries.

The MSCI World Index offers a broad representation of global stock markets, incorporating over 1500 companies from 23 developed markets around the world. This makes it a reliable barometer for the overall health and performance of the global stock market, making it a suitable choice for an analysis focused on long-term investment strategies.

This MSCI World Index experienced a devastating drop of 50% between 2000 and 2003 and an even steeper plunge of 60% between 2007 and 2009. The decade from 2000 to 2010 was a sobering one, far removed from the notion of doubling every ten years. I've calculated the returns for this article using the Bloomberg Terminal.

Analyzing historical cycles

In my opinion, investors could have known that there was a very high likelihood that returns between 2000 and 2010 would be heavily disappointing.

History has, in fact, provided several hints as to why too much return was front-loaded.

Take, for instance, the 20 years prior to 2000, during which the MSCI World Index skyrocketed by a whopping 1090%, while a 300% increase would have been more typical.

Let me illustrate that 300% with an example. An investor starts with $1000. Over a span of twenty years, it's anticipated that this $1000 will double twice. The first doubling takes the investment portfolio to $2000. The second doubling takes it to $4000. A return of $3000 on the original $1000 amounts to a 300% gain.

After 20 years, the investor would expect their portfolio to be worth $4,000. However, it had soared to nearly $12,000. If returns are significantly higher than what history suggests, then nothing other than front-loading of returns has occurred.

Zooming out to the period between 1980 and 2010 confirms this.

This means an extended period of 10 years, which indicates one additional doubling from $4000 to $8000. In those 10 years, as previously mentioned, there were no returns to be garnered from equities of industrialized nations; a decade later, the investor still had around $12,000. However, this is still more than what would have been expected when buying shares thirty years earlier.

Now that we understand that stock returns can sometimes be much higher than average and at other times much lower, let's examine how we can incorporate this knowledge into an investment strategy.

My investment strategy

My strategy is simple and is based on a 10-year cycle. Ten years is often enough to encompass an entire economic cycle - from panic to euphoria - and offers valuable insights for the future. After a good or bad year, what follows appears to be random.

However, a 20-year span can also be helpful in determining the relative value of stocks.

This approach leads to a clear rule: I only invest in the MSCI World Index if the return over the past 10 years is less than 100%. A return of less than 100% suggests that no returns have been front-loaded, increasing the likelihood that the developments within companies have been even better than the movement of stock prices.

Over the past 10 years, the return of the MSCI World Index has been 149%, which is much more than we, as investors, should have expected. An investor buying into the MSCI World now is likely paying too much, and as a result, returns over the next 10 years will probably be disappointing.

The following chart displays each point on the blue line representing the return of the MSCI World in the prior 10 years. It becomes abundantly clear just how prosperous the 80s and 90s were for stocks from advanced economies.

One of the most crucial lessons is that, over a 10-year period, stocks don't move based on company performance but rather on how stocks have performed in the decades prior.

After all, during the first decade of this century, the total revenue of the MSCI increased by 55%, and the overall profit surged by 66%, yet the stock returns were dismal despite this growth.

20-year chart.

It does not matter whether the investor looks at a graph with returns over the past 10 years, because the conclusion is also exactly the same with returns over the past 20 years.

The chart depicting the returns of the MSCI World over a 20-year period clearly shows a pattern: the worse the returns were over a 20-year span, the higher the subsequent returns.

The world seemed on the brink during the global financial crisis of 2008 and at the onset of the pandemic. However, up to now, these moments have turned out to be the best buying opportunities for my generation.

Key Takeaways

There are two crucial lessons to be gleaned from this article. The first draws a comparison between corporate figures and stock prices to a man and his dog. Here, the man represents the evolution of the corporate figures, while the stock prices are symbolized by his pet.

The man walks with his dog tethered to a long leash. At times, the dog runs far ahead, just as the stocks of the developed world currently do. On other occasions, the dog lags behind, reminiscent of 2008. No one knows the exact length of the leash the dog is on, but it's clear that the man keeps walking at a steady pace.?

This suggests that the longer an investor holds on, the more their return tends to gravitate towards the average return of 100% over a decade. This trend is evident in the above chart, where the blue line invariably returns to the red line over time.

The "man and dog" analogy is drawn from the book "Against the Gods: The Remarkable Story of Risk" by Peter L. Bernstein. In this book [click here for the full book], Bernstein uses this analogy to elucidate the relationship between short-term fluctuations (the dog) and long-term economic trends (the man).?

It serves as a visualization to emphasize that while markets may experience significant volatility in the short term, in the long run, these fluctuations tend to follow a general direction dictated by more fundamental economic factors.

The second lesson underscores that if investors seek returns higher than 100% over the next decade, they must diverge from the MSCI World Index.

By the way, this strategy remains unaffected by global changes. Should countries from emerging markets evolve into developed nations, their stocks will naturally be incorporated into the MSCI World Index.

What If I'm Wrong

The upcoming decade could, of course, result in returns of over 100% for stocks from the developed world. History is replete with instances where stocks went from being expensive to even more so. Take, for instance, the speech delivered by FED Chairman Alan Greenspan in 1996.

Back then, he remarked that investors were suffering from 'irrational exuberance'. Greenspan observed that internet stocks were fueling unwarranted market optimism, not based on any genuine foundation of valuation, but rather on psychological factors.

I'm a strong advocate for the principle of buying a dollar's worth for fifty cents; I view this as a judicious strategy. However, purchasing a dollar's worth for one dollar and twenty-five cents, hoping someone else might pay one dollar and fifty cents for it, is a tactic that might work. But it does hinge on the next person seeing a very rosy future.

The most likely scenario is that the one dollar and twenty-five cents turns out to be worth just a dollar. When it comes to investing, it's crucial to minimize the chances of permanent capital loss, making it wiser to buy at a discount rather than at a premium.

Should valuations rise even more over the next decade, there's a good chance that the investments I've selected as alternatives to the MSCI World will also gain higher valuations.

That's why I confidently deviate from the index with my own investment portfolio. The specifics of how I deviate can be found in the blog: "My Top 10 Investment Picks Right Now ". This blog lists the investments that hold the most significant weight in my portfolio.

Conclusion

Using 400 years of historical data as a guide, we can deduce that an average return of 7% per annum over the long term is achievable when investing in stocks.

However, this data also reveals that stock markets are prone to significant fluctuations, with periods where the returns don't reach the expected 100% in 10 years.

The strategy that emerges from this historical perspective relies on the 10-year return of the MSCI World Index. When this return is below 100%, I perceive it as a favorable entry point, indicating that no returns have been pulled forward and there's room for growth.

With the current figure showing a return of 149% over the past decade, it seems stocks from the developed world are overvalued, suggesting the next 10 years might deliver disappointing returns.

Despite historical lessons, there remains a chance that the markets won't follow the predicted cycle's path. Hence, it's prudent for investors to consider adjusting their strategies and seeking alternatives outside the MSCI World Index to achieve the desired return.

The major advantage of my strategy is that investors increase their chance of returns and reduce the likelihood of underwhelming performances. After all, they are invested in stocks when the wind is at their back. And if they face headwinds, they can choose an investment where the wind favors them.

I hope this article has shed light on the potential power of historical analysis in determining your investment strategy.

Once a month I write an extensive blog post. Don't forget to subscribe if you don't want to miss the next edition. If you'd like to read such articles weekly, consider subscribing to the "Beleggers Belangen" magazine . If you're curious about my daily thoughts on financial markets, follow me on Twitter: @KarelMercx .