Rob Arnott is one of the few experts who predicted that the past decade was likely to be unpleasant for equity investors. In early 2002, he wrote a paper with Peter Bernstein that concluded that stocks were quite likely to under-perform bonds over the next decade. In mid-2009, having seen a long period in which bonds had, in fact, outperformed stocks, he wrote an article that was titled Bonds: Why Bother?
In this article, Mr. Arnott presents data to demonstrate that bonds have persistently out-performed stocks over a number of very long (multi-decade) historical periods. He then shows that when you look at price appreciation of stocks, net of inflation, there were three 20-30 year periods in the 20th century in which the real prce appreciation of stocks was less than or equal to zero!
Looking back 200 years, Arnott makes the eye-opening claim:
Out of the past 207 years, stocks have spent 173 years—more than 80 percent of the time—either faltering from old highs or clawing back to recover past losses. And that only includes the lengthy spans in which markets needed 15 years or more to reach a new high.
Arnott is concluding that even when the equity risk premium is positive, the gains will be made in a small number of years but that most investors (who will not be able to correctly time when they get in) are likely to spend most of their investing careers hoping that the market will regain its previous highs rather than making new highs.
What should we take away from all this? First, while there is no consensus among experts on the amount of additional return that investors should expect relative to bonds (the equity risk premium), we can easily observe that the equity premium can be negative for long periods of time. In other words, a high allocation to equities can end up in ‘gambler’s ruin’ in which people need to take their money off the table (out of the market) at a loss, even though we rationally expect that stocks should ultimately provide a substantial premium in return. On the other hand, there are plenty of experts (such as Roger Ibbotson and Jeremy Siegel) who maintain that significant exposure to equities is still most likely to assist in providing much-needed growth for investors planning for retirement income.
In a provocative essay in October, John West (who works for Arnott’s firm) suggests that they expect stocks (e.g. the S&P500) to return only 5.2% per year and bonds to return only 2.5% per year over the coming years. Returns at these levels would mean that investors in generic domestic stock and bond indexes, and in those that use these indexes as a benchmark, will need to save dramatically more than the the levels that most financial projections suggest. These returns, if they play out, also have substantial implications for pension funding–which is actually the primary focus of West’s piece.
In November, Arnott penned a follow-up piece in which he proposes his thinking for a solution. He suggests that the ways to beat the overall low returns from the equity and bond indexes are:
1) Wider diversification
2) Use of fundamentals such as dividend yield rather than market cap weighting
Arnott’s company does a lot of marketing on fundamental weighting to select stock and bond portfolios, so the second of these views must be considered in light of these commercial interests. That said, it is totally reasonable that diversifying beyond a generic stock-bond mix should add value. And increasing exposure to higher-dividend (typically low-Beta) securities can provide a valuable diversification benefit, according to my research and that from others.
My ultimate take-away with respect to Arnott’s research is that we cannot count on high returning stocks to solve our long-term problems of how to effectively invest for the long-term. We need to plan for a world with modest returns from equities, if for no other reason than that this may be the case. There are asset classes that we have reason to believe can help us to get more return with less risk in out overall portfolios, and we cannot afford to ignore these opportunities in the unfounded hope that a raging bull market will be the lottery ticket that saves our retirements.