Bloomsbury blog Triumph of the optimists

Bloomsbury newsletter, 31 December 2020

Investors too often extrapolate the future based on their recent experiences.

In March 2020, who but the most rampant optimist would have dreamt, in the midst of the swiftest negative correction in sharemarket history, that most global sharemarkets would recover to deliver positive returns by year’s end? Yet this is precisely what happened. The optimists triumphed. It was such a remarkable outcome that it brought to mind the timeless research of noted economist Elroy Dimson.

Very few historians of finance have reached the heights of Professor Dimson. He is the Emeritus Professor of Finance at London Business School and his work has been cited over 10,000 times in academic articles.

He has written and edited books such as “Financial Market History: Reflections on the Past for Investors Today” and the “Global Investment Returns Yearbook 2020”, but he is perhaps best known for a book first published nearly 20 years ago, the boldly titled, “Triumph of the Optimists: 101 Years of Global Investment Returns.”

American philosopher Don Marquis once dryly observed, “an optimist is someone who never had much experience”. Well, Don Marquis never met Elroy Dimson.

In Triumph of the Optimists, Professor Dimson drew on the collective investment experience of over 100 years of financial market returns from 16 different countries, and in every case he and his co-authors found the same result, shares have higher returns than bonds and cash, often substantially higher.

In his findings at the time, he wrote, “In the United Kingdom, equities provided an annualised return of 10.1%, or 5.8% after adjusting for inflation. The best performing equity market was Sweden, with a real return of 7.6% per year, while the worst was Belgium, with an annual real return of 2.5%.”

Below we show the full chart of results detailed in Dimson’s book. Although they are, admittedly, about 20 years old, the broad findings continue to remain very relevant today.

Figure 4-7: Real returns on equities vs bonds internationally, 1900-2000

Despite a year of uncertainty and upheaval, 2020 has ultimately been a triumphant year for the optimistic investor.

When the NZX lost about 30% in 30 days in late March, the news headlines were dominated by pessimism. Many businesses faced the prospect of closing down for an unknown period of time. The logic seemed painfully obvious. No customers means no profit, and no profit means businesses were going to either suffer or fail altogether. At the time you couldn’t blame someone for thinking that continuing to own shares in such an environment was not a good idea.

But since the markets hit their low in March, from that point to the end of December 2020, the NZX 50 Index (total return) has been up by over 54%.

We know that investing in shares holds a certain level of risk. This year has proven it so. Professor Dimson has a wonderful quote about risk that is based on his extensive research into the history of financial markets.

“Risk,” he says, “means more things can happen than will happen. It is not standard deviation. It is not variability. It is this sense that future events are highly variable and unknowable that gives us the best sense for risk.”

A global pandemic is an example of something that ‘could’ happen. And there are many other things that too could happen. But as share prices represent the best guess we have of the future value of a firm, and because future events are highly unknowable, shares are inherently risky.

However, over 100 years of financial history tells us that while anything can happen, and sometimes does, the value of businesses which can nimbly adapt to the environment of the day, will have the best opportunity to grow and to thrive over time.

That may not be the case every year, but over time horizons spanning decades (similar to the time horizon of most investors) it almost certainly will be. As for investors that do not have that long term time horizon or don’t like the market rollercoaster, holding other assets in combination with shares may be more prudent.

Like you, we are happy to see 2020 in the rear-view mirror. But hopefully this experience has done for each of us what Professor Dimson discovered in his research, that optimists can truly triumph.