Learn from the past about the future

By Brent Sheather

Historians tell us that those who ignore history are doomed to repeat it. Many investors expend a great deal of energy charting share prices to try and spot trends, turning points and the best times to buy and sell.

While the benefits of this sort of analysis are open to debate, there is a lot we can learn from looking back at the returns which various investments have produced in the past.

One key lesson is that over the long term, shares have out-performed other investments. Since the mid-1920s, money invested in the shares of the 500 largest US companies has grown by an average of just over 11 per cent a year, much more than competing investments and well ahead of inflation, which averaged around 3 per cent over the same period.

If you are wondering about the reason for using data from the US, I have done so because the US sharemarket is the world's biggest and most liquid and, most importantly, reliable data for it exists from well before the turn of the century. Because the US sharemarket is so large - representing almost 55 per cent of the world's stockmarkets - investors elsewhere use it as a benchmark for valuations.

But how relevant is it to look back over the best part of a century? What does it tell us about the chance of our sharemarket investments losing money over, say, five, 10 or 20 years? Well, history shows that if you divide the past 70 years up into five-year periods, in only one out of every ten of those periods have share prices fallen - again looking at US shares.

If you look at 10-year periods, the chance of losing your money was even less, and there have been no 20-year periods in which share prices fell.

It is also worth noting that most of the five-year periods in which share prices fell occurred during the depression of the 1930s. To me, the most important lesson of history is that on average the sharemarket does well and is resilient - it bounces back, eventually, after crises, wars, depressions, elections and assassinations.

To my mind, a "buy the average" strategy (rather than trying to pick winners) is threatened only by global nuclear war or invasion by aliens. If either of those issues worry you then shares are too risky. But if you are impressed by the long run returns, why try to beat them, even if that is what many private and institutional investors unsuccessfully try to do every day.

History tells us something else too - the high returns experienced on many markets in the last ten years or so have not been normal.

US shares, for example, have returned more than 19 per cent in the past ten years, much higher than their 11 per cent average return over the past 70 years or so.

Fixed interest investors putting money into US Government bonds have also enjoyed higher than normal returns. The single biggest reason for those higher returns has been falling interest rates. And the reason rates have fallen? Lower inflation. The US central bank - the Federal Reserve - recently estimated that every 1 per cent fall in inflation translates into a 20 per cent rise in share prices.

However, interest rates cannot fall forever, so we should be prepared to accept that future returns from shares are more likely to be closer to their historical 11 per cent a year rather than the spectacular levels of recent times.

Even the historic average may be excessive. Some prominent academics argue that - given the excessive returns of the past 10 years - international share markets will be struggling to produce 11 per cent in future. While there is nothing investors can do about these returns, they should be aware of the costs they are paying to achieve them.

These may not have been so important in the recent past, with overseas markets performing strongly - especially as the New Zealand dollar has fallen, further boosting returns for local investors with money overseas.

However, as returns fall back to their long-term averages, many investors will find that costs are eating up half their returns, before tax and inflation take their share.

* Brent Sheather is a Whakatane sharebroker and occasional contributor to the Business Herald.