Many conversations about investing this year are centered on what is wrong with stock markets in 2011. The assumption underlying this concern is that markets are only acting correctly when prices move higher, like in 2009/10, and are therefore defective when they move lower.
There are however, periods of time when economic risk is higher; the global debt problems and Japan’s difficult natural disaster come to mind. In some time periods earnings are generally not growing. If markets are discounting higher risk then it stands to reason there should be some additional volatility and in this past quarter at least, uncertainty has resulted in lower stock prices.
Markets work properly when they can move both higher and lower. If common stock prices were simply pegged higher each quarter then they would not well reflect the variant conditions of the economy and society in general.
From 1970 to the end of 2010, total returns to stocks in Canada (S&P/TSX) and the US (S&P 500) have increased at a compounded rate greater than 10%. Inflation has been about 4% so real returns for the period are about 6% and investors have been well paid for accepting the risk of holding stocks. Not all decades are equal. The past 10 years have been less giving. In Canada the average returns since 2001 have been 6.6%. Inflation averaged 2.4% for a net of 4.2% in real inflation adjusted return. So the premium for holding risky assets has been below average.
How should this recent result impact our future expectations? Even in a below average return decade, patient investors did okay. They were rewarded with real returns and grew their money. While a definition of risk can be a future where “you don’t know the outcome,” long term averages should be attributed some predictive power. It seems to me that it makes more sense to consider a bigger sample (more years) than assume the recent experience will continue into the future.
There is plenty of risk in stock markets that is well rewarded and a source of good compensation for investors. There is also lots of risk assumed by the investment community that has no or perhaps negative compensation. Our investment focus is the elimination of risk that has no payoff.
Public stock market indexes have been a source of dramatic returns in excess of inflation for more than a hundred years. Investors can capture the returns to indexes at very low cost. However, there are problems with indexes. The S&P 500 for example is dominated by large growth companies. The calculation of the index has a bias toward large capitalization stocks. These features represent risk without compensation.
Another prominent example of non-compensated risk is assuming that stock markets provide risk free return by selecting only stocks that go up. Focus lists of investment houses are typical examples of this type of approach. The problem with these list approaches is they are not investable. You can’t be the first into the stock choices and the first out so the “return to the list” is not the investor experience. In my view, non-compensated risk like this should be minimized since they ultimately do not support the goals of investors.
Simple index returns can be improved upon. A better exposure to risk provides better compensation. We spend our time working at identifying risk worth taking and where possible, eliminating risk that doesn’t pay.
Patrick
September 9, 2011
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.




