Putting investment performance into perspective: looking back over two decades

Maarten Ackerman, Chief Economist and Advisory Partner at Citadel.

It is often argued that historical investment performance gives no indication of what might happen in the future. However, experience shows that the future will, most likely, fall within the boundaries set by long-term history. More than a century of returns are representative of nearly every possible economic scenario including: deflation, depression, war, hyper-inflation, booms and busts. An analysis of these returns can offer great insights into the longer-term behaviour of cash, bonds, equities and inflation under all of these scenarios.

After analysing investment returns in the US and South Africa over the past 110 years, we can draw the following conclusions:

1. Equities (global and local) on average delivered real returns in excess of 6% (all figures quoted are after inflation, before costs and taxes, unless otherwise stated). However, investors should remember that higher returns typically come with higher risk, which implies that equity investments can be more volatile than cash and bonds. Furthermore, these returns are typically achievable if investors buy at a discounted price – at low or below average price:earnings (PE) ratios.

2. Bonds and cash, on average, battle to consistently beat inflation over time, but can add good value as part of a well-diversified portfolio.

3. Recent performance is not necessarily an indication of future performance. Thus, be careful when selecting short-term or specific historical periods, like the past 20 years, as the base for future financial planning.

4. A well-diversified global portfolio should have generated about 3% real return per annum, after costs and taxes over the past century.

5. There is no such thing as a free lunch, and definitely no such thing as a free investment. There will always be costs involved with investing. Fund management fees, administration costs and portfolio management fees are the main cost components while taxes must also be taken into account. Therefore, the total “cost” of investing (tax and fees), can easily reach about 2.5% per annum – of which more than a third can be attributed towards paying tax.

How do the lessons learned over the past century compare with lessons learned since Citadel officially opened its doors in 1993? Our analysis shows that the past two decades have been an exceptional period with above-average investment returns generated by various asset classes – this over a period that included the Asian crisis, Russian crisis, dotcom bubble, 9/11 terrorist attacks, sub-prime crisis, Lehman Brothers’ collapse and European debt crisis. Furthermore, during this period globalisation matured and China joined the World Trade Organisation, both moves which have resulted in a doubling of the world economy’s “cheap” labour force.

We can draw the following conclusions from analysing investment returns over the past 20 years:

1. Global equities were the most attractive asset class, delivering real returns in excess of 6%. South African equities generated real returns in excess of 9% over the past two decades. South Africa benefitted from an emerging local middle class, strong commodity demand from China and positive sentiment toward emerging markets.

2. Bonds and cash (both global and local) performed significantly better over the past 20 years compared with the past 110 years. Fixed income assets benefited from the sharp decline in global interest rates over the past two decades as inflation was brought under control, which contributed to above-average real returns.

3. Past performance is still not necessarily an indication of future performance. However, the past two decades generated above-average returns which specifically benefitted income assets on the back of interest rates falling to an all-time low.

4. For a South African investor with a well-diversified portfolio that included global assets, the past 20 years should have generated a real return, after costs and taxes, of over 4% per annum.

What can investors expect over the next decade?

The typical investor tends to expect near-term performance to continue indefinitely, whether it is favourable or unfavourable. At the same time investors frequently want returns that match or exceed the top-performing indices or asset classes over specific time periods. We know that the market moves in cycles and typically reverts back to the longer-term mean. So, what could investors reasonably expect over the next decade?

1. Equities should be able to generate real returns close to their long-term average of 6%. The global economic expansion should be sustained, thereby enabling companies to maintain profitability. Most equity markets are still trading at some discount (looking at their long term PE ratios) and therefore they present reasonable value.

2. The significant performance generated from fixed-income assets over the past 20 years is unlikely to be repeated again. Global interest rates are likely to slowly normalise over the next couple of years as the global economic recovery continues. This normalisation of rates should weigh on the capital value of fixed income assets, most likely resulting in below average returns over the next decade. Investors should probably expect negative real returns from this asset class over the next couple of years.

3. The more than 4% real return generated by a well-diversified global portfolio over the past two decades is unlikely to be repeated and investors can reasonably expect about a 3% real return (after costs and tax) from a well-diversified global portfolio over the next few years.

Wise investors ensure that their portfolios are diversified both globally and in terms of asset classes, but they also need to plan for a generally lower return environment and take that into account when establishing their investment strategy and executing their financial plans.