The "patience premium": why stocks are superior long-term investments
Chapter 10 of "Getting a better class of enemy", my investment book
I'm writing an investment book called "Getting a Better Class of Enemy - Money, Markets and Manias". As I write the chapters, they will be made available to paid subscribers to OfWealth. Previous chapters, along with the Preface and Chapter Plan (which are free to all readers), can be found by clicking on this link.
The reason for the title is that, as your wealth grows, there are a lot of potential "enemies" that will try to take it away from you. These are explained in Chapter 1.
"Money can't buy you friends, but you do get a better class of enemy."
Spike Milligan, Irish-English author and comedian (1918-2002)
Chapter 10 looks at what I believe are the real reasons that stocks outperform other choices of investments, such as bonds. At least, in the long run.
I don't believe that it's because stocks are "more risky", meaning that investors must require a higher return to compensate. At least, not at the portfolio level. It's something far more intrinsic than that.
The chapter also points out the major flaws in the main financial theory that claims to calculate the required returns from stocks.
This is quite a long chapter, and some email systems may clip it (for those receiving it that way). In which case, you can read the whole thing at this link.
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Chapter 10:
The "patience premium": why stocks are superior long-term investments
"Happily there is nothing in the laws of value which remains for the present or any future writer to clear up; the theory is complete."
John Stuart Mill, English philosopher and political economist, written optimistically in 1848.
Standard financial theory says that riskier investments deliver higher returns to investors. It also says that stocks, being riskier than bonds, must deliver higher returns, at least in aggregate.
Both of these ideas are partially right, but also very wrong in some important ways.
To the first point, riskier investments don't always deliver higher returns. The mere fact that they are riskier means that both the size and probability of loss are higher than lower risk alternatives.
If you invest in a mining exploration company with operations in an unstable country, there is a large chance that you will lose a lot of money, or all of it. To compensate for this high risk, there must also be a chance of making a huge profit.
Somewhere in the middle of the extremes of huge gains or losses will be the probability-weighted "expected return", and this must be high enough to make up for the high risk. That's as compared to, say, owning short-maturity government bills or bonds with a known yield-to-maturity. If you hold those until they mature you have a guaranteed nominal return, provided that the issuing government doesn't default on its debt.
In other words, riskier investments must have a higher expected return than less risky alternatives. But they will often result in major loss. Which is why portfolios of very risky stocks must be far more diversified than portfolios of less risky stocks, if investors want a decent chance of coming out on top.
In practical terms, this means you might get away with a handful of stocks of mature, market-leading companies in essential industries and have little chance of making a loss, given time. Whereas anyone investing in high-risk venture capital type companies, that offer the prospect of very high future profit growth but also a high risk of failure, must diversify much further. That means across dozens of individual companies, if you want to have little chance of getting wiped out at the portfolio level. You don't bet the farm on single high-risk companies, or even small groups of them.
Moving to the second original statement, about stocks in general having to deliver higher returns because they are riskier, things are more nuanced.
As explained in the previous chapter, common stocks (or ordinary shares) represent part ownership of the shareholders' equity of a company. Listed stocks are a type of tradeable financial security that form part of the capital structure of a company.
The other main type of company capital is debt. This can take the form of bank loans, or bonds issued to investors in the form of tradeable securities. There are hybrid structures in between debt and equity, such as convertible bonds and preference shares, and many variations of those. I don't propose to explain them all here, as the focus is on common stocks.
Each of these forms of capital sits within a seniority ranking. If the business becomes insolvent, this means they have varying claims against the liquidation value of the company.
For example, a loan that is secured against a specific piece of real estate collateral means the bank can seize that asset to cover what is owed, in the event of a loan default. Different bonds issued by the company will have varying levels of rights written into the bond contracts, and thus varying levels of risk (meaning they are also issued with varying levels of coupon payments).
At the bottom of the seniority ranking sit the company's common stocks (ordinary shares). Thus, in a liquidation scenario, shareholders may receive very little or no cash compensation, once all the company assets have been sold and all other liabilities paid.
In this sense, stocks are clearly riskier than bonds. If you could invest in only one company, you should demand a higher expected return from buying the shares than from buying the bonds. However, in the real world, there are many thousands of individual stocks to choose from.
This means that the insolvency risk of owning shares, from them being at the bottom of the seniority ranking, can be diversified away to the point of being insignificant.
If you own a diversified country index fund, or several different index funds, then you will be a shareholder in dozens, hundreds, or even thousands of individual companies. Some of them will get into financial difficulty, resulting in major or total losses for their shareholders. But others will perform better than expected, providing an offset.
The net result is that the risk that stems from the low seniority of equity in the capital ranking is effectively eliminated, or becomes so small as to be irrelevant. What's true at the individual company level is not true at the diversified portfolio level.
Most of this risk can also be eliminated in more concentrated portfolios of individual stocks. If you divide your investments equally across 20 stocks then you will have 5% invested in each company. That means you can only lose a maximum of 5% of the portfolio value if one single company goes bust. Already, much of the capital ranking risk has gone.
But it can be reduced much, much further with sensible stock selection. For example, if all the companies have the following characteristics: among the market leaders in their industry sectors, cash rich or low / no debt, profitable all or most of the time, competent senior management with a good track record, and mainly operate in relatively stable countries.
If all of your chosen stocks tick all or most of these boxes then it's unlikely that any single one of the underlying companies will go bust, let alone more than one of them in a group of twenty. Of course, it's still possible in an uncertain world, and you need to make sure that each company doesn't head in the wrong direction suddenly, such as undertaking a massive acquisition at a high price that's financed with huge debt. But, barring such events, the insolvency risk in such a portfolio is extremely low, as long as the outlined characteristics are maintained.
Note that this doesn't mean that the stock prices, individually or collectively, can't still fall sharply, either for a short time or a prolonged period. Good companies can still have bad years, and general stock markets can still suffer sharp falls, dragging everything down with them for a time. I'm just talking about eliminating most of the risk associated with equity being at the bottom of the pile in the capital stack, in company liquidation scenarios.
Of course, there is a paradox here. Although individual stocks are riskier than bonds from the same issuer, due to their position in the capital seniority hierarchy, the insolvency risk can be eliminated for practical purposes via diversification. If this was the only risk, then we could say that a diversified portfolio of stocks is no riskier than a portfolio of bonds, and therefore equity investors shouldn't require a higher return than bond investors.
But, despite investors' ability to diversify away the insolvency risk with relative ease, at the individual company level the managers should still act in a way to deliver a higher return to shareholders than to bondholders. Hence the paradox.
This is one reason that stocks overall should deliver higher returns than bonds, on average. Management investment decisions within the companies should be attractive for stock investors, on average. But, as I'll explain later, the higher average returns amount to an intrinsic feature of stocks. They are not the result of stock investors taking higher risks, provided that portfolios are appropriately diversified (across indices or companies with the aforementioned characteristics).
In fact, most company-specific risks can be diversified away, or reduced further by only investing in strong companies. Company-specific risks include bad strategic decisions in future, poor acquisitions, the appointment of an incompetent management team, companies failing to evolve as new products replace the old, and so forth.
What can never be eliminated are macro risks that affect specific groups of companies, or all companies. But the question is whether these general risks make stocks riskier than other investments such as bonds. And thus whether this is a separate reason why investors should demand higher expected returns from stocks to compensate.
A lot of macro risks stem from policy decisions made by governments and central banks, or geopolitical events such as wars and revolutions. Such risks include things such as higher taxes, mandated price fixing (including minimum wage legislation), excessive government borrowing or debt defaults, capital controls, inflationary money printing, physical asset destruction, or outright confiscation. For example, anyone that owned local stocks (or bonds) during the Russian or Chinese communist revolutions faced a 100% loss, as all private property was confiscated by the state. Those were extreme examples, but governments have plenty of other ways to destroy value.
Obviously, such risks are ever-present and must be monitored, whether at home or abroad. Only the brave will invest in the least stable countries, whether politically or economically, and even then they should demand very high potential profits if things don't fall apart.
It's also worth remembering that stocks listed in seemingly lower-risk countries are often of multinational companies with significant operational exposure to riskier places. That could include where they sell products, the locations of their production facilities, or where their suppliers are based. It's something to look out for, especially when selecting individual stocks for a portfolio.
Other macro risks can be of a general economic kind, rather than as a direct result of the actions of governments and central banks. Economies go through economic cycles, commodity prices can boom and bust, credit availability can be easy or tight.
All macro risks are of course a concern for investors in stocks. But aren't they also a concern for investors in other things, such as bonds?
For example, let's say you own a 10-year government bond with a 4% yield to maturity. That means that if you own it until maturity, collecting coupon income and eventually receiving repayment of loan principal (the face value of the bond), then you will make a guaranteed return of 4% a year. Although the bond price will fluctuate along the way.
That's okay if inflation averages 2% a year, giving you a 2% real (above-inflation) annual return. Not huge, but at least positive in real terms. But what if inflation ends up averaging 5% a year due to the misguided policies of the central bank or government? Then you lose 1% a year in real terms, guaranteed.
Meanwhile, if inflation goes up then stock prices are likely to go down in the short term, as business input costs increase, thus crimping profits, and also as stock valuations are reduced. But, given time, companies will increase their product prices and/or find cost efficiencies, and profits will increase again.
Over a 10-year period, there is still a high chance of making a real return, above inflation, as those higher profits are reflected in the share price. That's especially true if inflation comes down again eventually, but with profits now re-set at a higher level. In other words, stocks become the lower risk investment than bonds in such a scenario, at least if the investors are patient enough to see it through.
In short, both stocks and bonds are exposed to macro risks, although they will react to different scenarios in different ways. But, in the long run, there is at best a weak argument that bonds are less risky than stocks, and therefore that bond investors should accept a lower return. Put another way, the longer the investment period, the less risky that stocks become and the more risky that bonds become.
If in doubt, just consider the long-suffering investors in US government bonds during the long bear market between 1945 and 1981, which was a stretch of 36 years. Over that time, they lost around 60% of their money in real terms, meaning after inflation. In the same period, investors in US stocks made more than six times their investment, again in real terms.
I've explained how the risk of equity's bottom-rung seniority ranking and company-specific risks can be eliminated, for practical purposes, in a diversified portfolio. This can be achieved by investing in a broad stock index, or by owning a smaller portfolio of diversified stocks, especially if they are all of strong companies. Meanwhile, macro risks are present for both stocks and bonds, and stocks will typically be the lower-risk but higher-return investment over long time periods.
So is there another "risk" that means stock investors should demand higher expected returns than bond investors? This brings us back to our old friend price volatility, and the need to pick apart a piece of financial theory.
The investment industry is obsessed with price volatility, and conflates it with "risk". While it's true that stock prices can fall sharply in the short term, the risk of loss diminishes as the investment period gets longer.
Chapter 5 looked at how the risk of stock investing reduces over longer holding periods, with reference to historical evidence. Chapter 8 also included a discussion about why there is an obsession with volatility in the investment industry, and some flaws in that way of thinking.
The bottom line is that investors should only commit capital to stocks if they can wait a sufficient amount of time to be reasonably certain that the investment will pay off. I recommend assuming a minimum investment period of five years, although stock investments will frequently perform well over shorter periods.
Even investing in a diversified stock portfolio, such as the S&P 500 index of large US stocks, there is perhaps a 15-20% chance of losing money over one year. That's because, historically and over the very long run, there has been a significant market fall on average every five or six years. But over ten years the risk of loss becomes very small, and progressively smaller over longer periods. That's unless the original purchase was made at a seriously inflated price near to the peak of a speculative bubble (1929, 1968, 2000 in the case of the US, 1989 in the case of Japan, etc.).
What's certain is that short-term investors should stick to assets that have fairly certain outcomes when it comes to any money that's likely to be needed within a few years. Suitable short-term parking spots include bank deposits and short-maturity government bills and bonds. The returns will be low, but the money should be there when you need it, barring a major financial crisis (for which a long-term holding in gold provides some protection).
So yes, stocks are "riskier" in the short term. But not necessarily in the long run.
Either way, there is a standard method that is meant to calculate the required returns from stocks. But it takes no account of investment holding periods. This is known as the Capital Asset Pricing Model, or "CAPM" (usually pronounced "Cap Em").
It's important to understand the basics of it, and its flaws, before we can turn to the real reason that stocks outperform. So let’s take a closer look.