Recently I came across a chart on Twitter which reminded me of a paper I’d read about long-term stock charts.
That got me thinking about index investing in general; how popular it is and whether or not there might be any hindsight bias in play.
Passive index investing has more supporters than any other strategy but what if that popularity is based on a one-sided view of the past?
Index Investing Is In Vogue
Everybody from Jack Bogle (RIP) to Warren Buffett to Tony Robbins has good things to say about index investing.
A lot of the popularity boils down to the fact that low-cost ETFs have proven difficult to beat.
“Index investing will do better on balance than going to a professional. Because the professionals, after fees, don’t know how to get a better result.”Warren Buffett
So index investing is regarded as a simple and effective way to invest.
But what if this view is clouded by the fact that indexes have simply performed well over the memorable past?
Stock markets have done remarkably well since the second world war but this pattern doesn’t necessarily hold throughout history.
The next few charts provide some food for thought and pose some interesting questions for all fans of buy and hold index investing.
1. Stocks In The 1800s
Everyone is familiar with a chart of the stock market from around 1900 or 1930 to the present day.
What you get is an attractive upward sloping curve with small blips now and again from bear markets like the Great Depression, 1987 and 2008:
It’s from long term stock charts like these that most conclusions are made about long-term stock returns. Specifically that they return around 6-8 per cent over long periods.
However, charts like these often include a couple of assumptions:
- They are usually total returns and not adjusted for inflation.
- They assume the continuous reinvesting of dividends.
The next graphic shows a much more unfamiliar chart:
These are real price returns (after inflation) on US stocks between 1851 and 1931 without the reinvesting of dividends.
This was a period of deflation and as you can see, this 80-year period resulted in negative real returns for investors who didn’t reinvest dividends.
If you’d invested a lump sum in 1851 and cashed out 80 years later (a whole lifetime) you would have been no better off.
In fact, looking back through history there are plenty of long stretches (30 years or more) where stock markets didn’t return anywhere near the 6-8 per cent benchmark.
For example, “investors who bought in the summer of 1929, and held only until the summer of 1982, spending dividends along the way, would have seen the real value of their portfolios drop by 40%”, according to the same paper.
2. The Case Of Japan
The case of Japan (and other countries like it) provide another example of stock market investing going awry.
As the next stock chart shows, Japan’s stock index the Nikkei 225 is still trading well below it’s 1990 high. That’s 29 years of woeful performance in Japanese equities:
And Japan is not alone among countries that have produced long stretches of poor performance.
If you happened to live in Italy between 1900 to 1979 you may well have lost money with a buy and hold approach.
The Italian stock market produced a real return (without reinvesting dividends) of only 0.8% during this time. And between 1960 – 1979 it lost -6%.
Likewise, Belgium saw a total real return of -1.7% for the 49 years between 1900 – 1949.
And Spain saw a return of only 0.1% between 1910 – 1979.
These are all long periods of stagnation.
One of the big lessons to draw from this is that you must reinvest dividends or face the possibility of poor returns over a long stretch.
3. UK Real Earnings
This final chart doesn’t show stock market returns but it’s related.
After all, wages, productivity, economic progress; they all impact on the growth of businesses and that affects the return of stocks.
As you can see from the next chart, UK real earnings went on an unprecedented rally from the mid 1800s to the present day (with a slight blip that we are experiencing now):
No doubt this surge in real earnings coincided with the industrial revolution and the rise of the UK as a global power.
The point is that for long periods real earnings has been either flat, declining or only gradually increasing.
Between roughly 1400 to 1629 (a stretch of 229 years) you can see that real earnings were in continuous decline.
If we had invested in markets during this time it’s likely that we would have also seen poor returns.
The next chart is the earliest I could find for the UK market and shows a flat period between 1700 – 1820:
(Note: You can find data like this in a publication called ‘a millennium of UK macroeconomic data’ produced by the Bank of England which I have included here.)
A New Economic Order?
It’s always a worry when everybody jumps onto one side of the boat which is what we have seen with passive index investing and buy and hold.
This approach sounds reasonable enough and it looks good on paper over the last few decades in the USA.
But do a little digging and you can find long periods in history when index investing wouldn’t have worked out so well.
The odds of this investing style succeeding in the future are probably high, particularly with a diversified approach that includes many different countries.
But equally, we can never know what the future will bring. What if we were to see a new economic order develop?
We could see a big change similar to the change that came with the industrial revolution.
Something that is more decentralized and flatter than our current capitalist systems might redistribute power away from the big corporations to thousands of smaller niche-operated companies.
Societies might spread out and more people would become self employed.
We will always need businesses but the advantages from economies of scale might be reduced through technological progress.
Maybe we are already seeing these changes take place? For example with cryptocurrencies, political upheavals, 3D printing and automated work by robots.
I am mostly brain storming here and I don’t want to speculate too much about the future. Index investing is going to remain a reliable approach to investing that is suited to many.
Especially if it is well diversified across countries and asset classes and combined with dollar cost averaging and the reinvesting of dividends.
But in my view there will always be room for market timers and stock pickers. In a new world order, this will be even more true.
As the charts on this page have shown, stock markets and global economies can go for long periods with poor returns. It certainly can happen.