A Closer Look At Equity Cult Comments Reveals Some Important Investment Truths

Monday, October 01, 2012 08:32
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A Closer Look At Equity Cult Comments Reveals Some Important Investment Truths

Tags: bonds | investment strategies | investor behavior

Bill Gross’s comment disparaging investing in equities by labeling it a cult did make a valid point: expecting a real rate of return of 6.6% in a market that’s only growing by 2% - 3% is unrealistic.

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A 6.6% real rate of return reflects an expectation that insults the intelligence of bond investors, implying that their ignorance and version to risk leads to a wealth of gains for equity investors.
 
Productivity gains in the economy would only be awarded to equity investors.
 
But equity investment during the 20th century can’t be ignored. A $1 investment in Treasury Bills grew to $18 between 1926 and 2001. A $1 investment in equities over the same period grew to $1606.
 
The assumption is this outperformance is because investments in T-Bills are less risky than equities. It also means there should be times when equities underperform.
 
Asked to measure the opportunity cost for avoiding investment in equities, Wade Pfu, associate professor at the National Graduate Institute for Policy Studies did a study based on the results of investing in a 30-year bond at prevailing rates along with a 30-year equity portfolio and treating the bond as an amortized loan, like a mortgage.
 
This would replicate an investor taking a loan on a paid-off home and investing it in the stock market.
 
The results represented the transfer of wealth from bond holders to equity investors over a 30-year period. If markets are indeed efficient and long-term risk is valid, bond investors should have outperformed equity investors at least part of the period.
 

Timing over the period was important. If an investor chose to build an equity portfolio between 1928 and 1931 and held it for 30 years, they were out of luck. A $100 investment begun in 1932 grew to $901 by 1962 after paying off the loan. $100 invested in 1993 grew to $1064.

 
Those who borrowed $100 in bonds and invested the money in equities in 1942 saw their money grow to $1156. If you started in 1943, it grew to $1192.
 
Another of Gross’s points is that the new generation of investors may have become disenchanted with equities. Stocks are generally thought of as carrying higher risk than bonds, thus accounting for the greater returns.
 
But the more people invested in stocks, the more the risk premium falls, creating the potential for stock returns to be lower than bond returns.
 
If companies are able to borrow at rates below their growth rate in profits, they can receive a higher rate of return on equities indefinitely. A cultish atmosphere of equity investing can cause investors to make uninformed choices.
 
If investments fail to return far above the rate of true wealth creation, investors must work longer and expect lower returns on their holdings.

 

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