Western economies face a danger of continued secular stagnation – what former US treasury secretary Larry Summers calls a “chronic excess of saving over investment”. This causes real interest rates to be negative (and nominal interest rates as well, in much of Europe). What should equity investors do about this?
The answer is not to buy more shares. Yes, it’s tempting to regard negative real returns on cash and bonds as attractive and chase the decent returns that equities seem to offer.
Doing so, though, is risky. The lack of investment opportunities that drove real interest rates down may also reduce real economic growth. That in turn would force share prices down. There’s a reason why so many investors are holding bonds despite their negative returns; they fear even worse returns on equities.
They may be right to think so. There are two other implications for long-term equity investors: one is something we should do, the other something we shouldn’t.
Dividend reinvestment is powerful
What we should do is reinvest dividends. In the long run, dividends account for most of the returns on equities. For example, if you’d invested $1000 in the MSCI world equity index when it began in December 1969 you’d have over $20,000 if you’d been able to reinvest them tax-free (as you can with some pension funds). You would only have about $5500 if you had spent the dividends.
Dividends, then, have accounted for three quarters of the real returns on shares. The 1.7% yield on the MSCI world exchange traded fund might not sound much. But if we do enter a phase of secular stagnation, it might well exceed economic growth and hence the likely growth in share prices. And over the years, 1.7% compounds nicely.
Remember risk versus reward
This does not, however, mean you should buy higher-yielding shares. Granted, these have tended to outperform other choices over the long run. But this might only be a reward for taking on extra risk. Many value stocks have done badly in recessions, for example. And if real GDP growth is going to be lower on average in future the risk of recession is greater.
TV’s The Simpsons and “creative destruction”
In fact, there’s a strong case for longer-term investors not picking individual stocks at all. This is because of something pointed out by Austrian economist Joseph Schumpeter back in 1942. Economic growth, he said, is a process of creative destruction: new firms are created and old ones destroyed.
The long-term investor who bought particular US stocks in the 1980s and 90s and did not rebalance his or her portfolio might well have held Enron, Chrysler, Lehman Brothers and several airlines, all of which went bust, but not Apple or Google. The investor would be like The Simpsons’ character Montgomery Burns, who thinks of Transatlantic Zeppelin and Amalgamated Spats as blue-chip stocks.
Jeremy Greenwood and Boyan Jovanovic have shown how important creative destruction is. They’ve estimated that all the massive growth in US share prices between the 1970s and 1990s came from firms that were not even listed on the market back in 1968. The firms that were listed then did badly.
You might think that slower long-term growth would mean less creative destruction. Less creativity, perhaps. But not less destruction. A world of unusually low growth is one where companies can easily fail, due to weak demand.
What’s the next Apple or Google?
You might also think you can spot future winners: the next Apple or Google. You probably can’t.
Many economists agree that corporate growth is largely random. “Financial performance and productivity do not predict growth,” concluded economist Alex Coad in a 2007 Centre d’Economie de la Sorbonne survey. Growth has “low predictability”, according to LSV Asset Management economist and chief executive Josef Lakonishok and colleagues in a study of US firms. And a report from the UK’s Department for Business Innovation and Skills found that “high levels of growth are not strongly persistent”.
All this is consistent with research from University of Florida finance professor Jay Ritter. He showed that new shares underperform in the months after they float. This tells us that investors pay too much for shares partly because they overestimate their ability to find the next Apple.
“The best thing to do is also the easiest”
The implication is clear: long-term equity investors should simply put their money into tracker funds and have the dividends automatically reinvested. Sometimes the best thing to do is also the easiest.