A world of choice in uncertain markets
Why a globally diversified basket of equities might be worth the risk over the long term
There’s a lot of truth in the old saying that investing is not about market timing but time in the market. If you have a sufficiently long time horizon for investing via a diversified basket of stocks then you should – if the past is anything to go by – benefit from a return that is in excess of cash (at the very least). The events in Ukraine are of course deeply disturbing and one doesn't have to be a glass half-empty type to think the impact of said events on stockmarkets may get even worse in the next few months. That said, stockmarkets do have a tendency to be turbulent, volatile and unpredictable. Indeed, that very volatility is why you might reasonably expect to receive a superior return over cash and even bonds.
Look at a chart for a well-diversified global index such as the MSCI ACWI (which includes some emerging markets) over the last 10 years and you might be struck by two observations.
Risky but rewarding
Firstly, there have been at least eight sell-offs where the index has lost around 10% from peak to trough during those 10 years, some of which I would wager investors have already completely forgotten about. In January 2018 for instance, this widely used index peaked then spent much of the year declining until it hit a low in late December 2018, after a near-20% decline. Other lowlights include the global financial crisis and the Covid panic.
However, look at that chart again and you'd also be struck by the general trend - upwards, substantially so, with the index more than doubling over the last decade (MSCI ACWI factsheet, 28/2/22).
The next ten years might be different of course, but history suggests that equities are worth the risk, provided you are patient. A study by investment firm Moneyfarm (Moneyfarm, 15/3/22) looked at returns from investing in the MSCI World Index (another global index) since 1970. This analysis tried to calculate the odds of losing money by investing in developed market equities on a year-by-year basis. In the first five years, the likelihood of a loss was 15% to 35%. But once you get past seven years, that probability slips to below 5%. By 12 years, it’s almost non-existent.
Stocks for the long run
To repeat: equities are always risky and always volatile, and if your time horizon is below five years (i.e., you might need that money urgently within the next five years), then maybe equities are not right for you. Any length of time beyond that and equities, especially a portfolio of internationally diversified equities, can produce very superior returns.
The evidence for this comes from the Credit Suisse Global Investment Returns Yearbook produced by academics Elroy Dimson, Paul Marsh, and Mike Staunton.
Their most recent report looked at 35 national markets (Credit Suisse Global Investment Returns Yearbook 2022), 23 of which start in 1900. The bottom line? Over the long-time span of the study, the extra return from investing in risky assets versus low-risk bonds was 3.2% a year, while the historical equity risk premium against treasury bills (short-term government debt) was 4.6%. In future, the academics expect a lower equity vs bills premium of around 3.5%.
They also note that from 1900 to 2021, the annualised real (i.e. after inflation) return for investing in UK equities has been about 5.4% a year, though that dropped to 3.8% from 2002 to 2021.
Take a global view
These studies also emphasise the importance of international diversification. Between 1974 and 2021, in terms of risk vs reward (as measured by the Sharpe ratio), UK investors have benefited from investing internationally. In fact, the only investors not to do so were Americans, who would have been better off sticking with their home market, which has produced stunning results. That’s also why most global indices are heavily exposed to US markets – US equities represent between 50% and 70% of the value of most global indices because it’s the most successful, liquid, and accessible market in the world.
How can investors build an international portfolio? You can buy a fund which simply tracks a global stockmarket index, but there are trends that an 'automated' index tracker might miss. For example, the bull market of the last decade has been powered by high-growth tech stocks. By contrast, cheaper stocks in less glamorous sectors underperformed. In the next ten years that pattern – growth good, value bad – might (or might not) reverse sharply, as it has in recent months. If inflation stays high for years, new trends may emerge. We might even see new geographical patterns emerge alongside those changes in style (value vs growth). Maybe Europe is too cheap, maybe China might continue becoming more important?
Active global equity fund managers argue that they might be better equipped to chart these changing patterns. But whatever the future holds one thing is for certain – a portfolio of diversified equities is likely (though by no means certain) to provide a superior return compared to the boring alternatives of cash and bonds. And if equities are a smarter home for the long term, then an international mix of businesses in one easy-to-access portfolio is probably a great place to start.
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When investing, your capital is at risk. The value of your investment may rise or fall as a result of market fluctuations and you might get back less than you invested. TWIM is the authorised Alternative Investment Fund Manager of Alliance Trust PLC. TWIM is authorised and regulated by the Financial Conduct Authority.
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