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This year's ups and downs in the world's stock markets have reminded investors that share prices can fall as well as rise, but has done little to dent the underlying cult of equity. With one voice, experts in Wall Street and the City of London have oozed reassurance. Sure share prices may be a roller-coaster ride in the short-run. But in the long run, their direction is clearly up. For anybody who is investing for the relatively distant future, especially those with retirement in mind, shares are best.
Nobody claims that this golden rule holds true for any individual company's equity. Buying a share in a company that underperforms or even goes bust would clearly be a lousy investment. But the argument runs, such firm-specific risks evaporate when the investor holds a diverse portfolio of shares. Jeremy Siegell, an economist at the Wharton School, summed up the conventional wisdom in a book, Stocks for the Long Run. Between 1802 and 1992, he calculated, investing in the American stock market generateda real return of 7 per cent a year on average. Long-term American government bonds produced an average real annual return of 3.4 per cent in the same period; gold produced a mediocre real return of one-tenth of 1 per cent a year. Even more impressively, says Siegel, ``one has to go back one-and-a-half centuries, to the period from 1831 through 1861, to find any 30 year period where the return on either long- or short-term bonds exceeded that on equities! The dominance of stocks over fixed-income securities is overwhelming for investors with long horizons.''
But how reliable is past performance of shares as a guide to what will happen in future? Will Goetzmann, an economist at Yale, points out that by focusing only on the American stock market, Siegel has chosen a sample data that is likely to give misleadingly impressive results. During the past couple of centuries, the American stock market has far outperformed other bourses. Indeed, in that time, many stock markets have gone out of business entirely, dueto revolution, nationalisation or financial collapse. When Goetzmann , looked at 38 other stock markets since the 1920s, including many that were closed for part of that period the average real annual returns o them were just 1.5 per cent. The high premium of American equities appears to be an exception, he concludes.
In the long-term most economists would expect equities to earn some sort of premium over bonds. They are riskier than bonds, and according to mainstream economic theory risky assets have to offer investors a higher average return. The trouble is, as Keynes observed, that in the long run we are all dead. For practical purposes, the crucial question is whether Siegel's observation that stocks outperform over a 30-year period can be relied upon in future..
Even unlimited data might not be enough. Analysing stock prices is not a scientific task. Share prices are the product of human opinions, which can be changeable and irrational. Some economists reckon that several human psychological biasesmean that shares are more likely to be undervalued compared with bonds, and so the wise, long-term investor should buy as many of them as possible. But people are quite capable of bouts of excessive optimism about investmentvalue. And sometimes this can take hold in a large enough part of the population to move prices well above anything that makes sense . History is littered with financial bubbles.
The fact that shares -- in America, at least -- have performed well over long periods in the past does not mean that a bubble could not push prices to levels that, once it bursts, would not be reached again for decades. In America, it was not until the late 1950s that the Dow Jones Industrial Average returned in real terms to the value it enjoyed immediately before the stock market crash of 1929. More recently, after peaking in the mod-1960s, the Dow lost two-thirds of its value in real terms by the mid-1970s, and it did not achieve a new real high until 1994. Neither of these periods were quite longenough to pass Siegel's 30-year test--but to investors struck in the market, they must nevertheless have seemed like a lifetime.
-- The Economist
Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.
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