Key Post The Cult of the Equity

Brendan Burgess

Founder
Messages
38,108
The downside...

First of all, let's deal with sleeping easily. I have seen my portfolio jump up and down over the years and I have never, ever lost sleep over it. If I had significant cash on deposit during the hyperinflation of the early 1970s, I would have lost some sleep. Even if someone is a worrier, I encourage them to put part of their assets in the stockmarket to see if they can handle volatility. If you worry about shares or about your Equitable Life pension or anything else, you should get out of it so that you can sleep easily. However, I do feel a lot of people have slept very easily over the past 20 years without realising that their deposits were being steadily eroded by inflation.

I would probably agree with you that there is a 10% chance that stocks will decline by 25% over the next 5 years. I think that the upside is greater than the downside, so I will hold onto my equities. But I don't tend to think in fixed periods of 5 years. I am 44. I would expect to be saving over the next 10 years or so. If prices drop, I will be buying equities cheaper, so it's not a huge problem to me.

If you are going to be spending your savings in 5 years time and a 25% drop would seriously affect your future happiness, then maybe you should settle for the gradual erosion of your wealth in a deposit account.

Brendan
 
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strader

Guest
C of E

Inflation erodes everything, not just deposit accounts. The question to me is will your balanced portfolio outperform the deposit account and by how much. If it will only be by 2 or 3 percent p.a., is it worth the additional hassle.
 

Brendan Burgess

Founder
Messages
38,108
3% is huge !

Hi Strader

While inflation does erode everything, there are usually real assets such as property and stocks underlying shares and the value of these rise with inflation. Deposit accounts remain static in nominal value and so decline in real terms. I am not saying that inflation is good for equities, it's just that they do have some inflation proofing qualities.

3% p.a. is huge and is certainly worth the hassle. £10,000 deposited at 3% for 10 years would amount to £13,400. £10,000 in shares at 6% p.a. would amount to £18,000.
Definitely worth the hassle

Brendan
 
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strader

Guest
3% is Huge

Hi Brendan,

I agree that in your example that 3% is huge-however, the deposit rate is guaranteed, while the stock market gain is not. With competition entering the deposit account market, and the "free " money gone from the equity markets, the deposit deserves some thought. Also, there are no commission or stamp duty issues.
 
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Sir Ivor

Guest
Re: The downside...

Brendan, I guess I have been making two arguments through this thread. My main argument is that equities could be already substantially overpriced (partly as a result of the CoE and vulnerable to more downside than upside. However, that is an opinion and we will just have to agree to differ. In any case most contributors side with you on this aspect.

My second, quite separate, argument is a utility curvebased one. I think we can both agree (in my case, for the sake of argument) that equities tend to come out on top over the longer term but that there is a reasonable risk of say a 25% fall over the medium term. Again, for the sake of argument, I am prepared to concede that the upside potential is greater than the downside risk from a purely statistical viewpoint. Clearly from the vantage point of yourutility curve you consider this a good bet.
 
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tyoung

Guest
cult of equities

This is a useful discussion and deserves more commentary. A lazy kind of thinking has replaced risk analysis. It goes something like this.
Equities are the best performing asset class over long periods of time. Therefore they should be the primary(sole)asset class for longterm investors.
You can't beat the market so don't try. Just buy the market.
Market timiing doesn't work so don't worry about valuations because of the above.(stocks always win and You can't pick winning stocks). Stop thinking and just buy index/tracker funds.

Equities are just an asset class that need to be valued in some sort of rational way. What is the rational response of investors to the knowledge of Equities' past outperformance and the widespread expectation that they will continue to outperform? They pile into equities pushing up valuations relative to other asset classes.
The present market selloff has unwound some of the excesses(bonds have outperformed stocks over 1,2 and 3 years in the US, UK, Japan and continental Europe for the first time since 1983) but expectations of equities are still too high. The sensible investor will not plan on more than mid single returns from stocks over the decade 2000 to 2010.
Investing and financial planning are not simply about maximising returns under normal market conditions. Nor are they about being able to sleep at nights They are about obtaining an ADEQUATE RETURN (to meet expected needs) under MOST market conditions .
 
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Sir Ivor

Guest
Re: Cult of the Equity

Quote from Eddie Hobbs in today's SBP

"...As they grow their balance sheets so does she. If they don't we're all finished, and it doesn't matter where she puts her money anyway

This is the line used to justify advising Fiona to invest her redundancy money in equities. Now this is the CoEat its most blind extreme! I've heard this line before - If our Blue Chip stocks do not perform, then that is the end of society as we know it, we may as well swallow a pill and get it over with.

Absolute Rubbish!

Current valuations (even after the recent slump) are already assuming a very healthy continued growth over the foreseeable future.

If that growth unfolds then current valuations wil be validated and equities will yield about 8% per annum as is currently in the pricing, albeit with a bumpy ride along the way, but about 3% p.a. better than gilts, so worth the roller coaster ride for those with strong stomachs.

If we get another burst of super growth then equities will again yield windfall gains as they have, at times, done in the recent past. I notice that EH in the same article has come up with a few South Sea Bubble possibilities of his own - Genetic businesses and Chinese specialist funds - wow!<

If growth stalls or slows then today's valuations have got it wrong and equities will lose around 50% of their value or more either steadily or in a series of mini crashes, as reality dawns. This is notthe end of the World. This is not nuclear meltdown. Just a more modest pace to human economic development than we have come to expect.

This is exactly what has already happened in Japan. No war. No revolution. No internal structural breakdown. No implosion of everyday living standards - the Japanese still live very comfortable existences, thank you (ok they have the odd earthquake). All that happened is that Jappen went ex growth, it could happen to any economy at any time and to all economies if it happens (is happening?) to America (and this is ignoring the apocalyptic possibilities alluded to by the late Sea Pigeon . We can observe that practically a whole savings generation in Japan have been badly burnt by the Cult of the Equity

EQUITIES ARE RISKY
 

Brendan Burgess

Founder
Messages
38,108
Re: Equity risk

Hi TYoung

It's better to post a summary of the article and the link, instead of just the link. That saves people from reading a lot of stuff which they might not be interested in.

I read the article twice. It's very long winded, foksy sort of stuff about the implications of the Twin Towers, which is summarised eventually in the 3rd last paragraph:
The principal risk to financial markets lies not in any crisis-induced loss of confidence, but rather in the consequences of the preceding overconfidence. Equity earnings yields of 3% imply an almost arrogant certainty. The future would be exactly like the present except better, the consensus of investment opinion has had it. It went without saying that peace would reign forever
It doesn't deal with the implications for inflation, bonds or deposits. Is war not inflationary ? Is there not a risk to the survival of some financial institutions - banks and insurance companies ? Yes, equities are risky in the short term and, maybe a little risky in the longer term. But I would be at least as worried about deposits at the moment.

Brendan
 
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tyoung

Guest
Cult of Equities

Hi Brendan,

Dear Me, I had no intention of wasting anybody's time. If I could write as well as Jim Grant, I would have a different day job!
You are correct about the second link.That is an indication of my computer skills(or lack thereof). At the risk of adding to your boredom I think this is the correct link.

www.grantspub.com/special...9n16c.html


More boring stuff about how overvalued the market is and that the popularity of index tracking is a symptom not a cause of this overvaluation.
The Irish Market never got as overvalued as the US market. Certainly Continental European markets did, but that being rapidly corrected. How is the Euro stocks 50 doing anyway?
Best Wishes
 
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Sir Ivor

Guest
Re: Cult of Equities

These are great links tyoung. But I remind AAM that said much the same thing on the 24th August.

This was driven partly by unprecedented technology induced productivity gains in the Western economies but most of all it reflects a sort of peace dividend for the new Pax Americana.

Saddam had been put in his box. Western oil supplies are secure. Capitalism's nemesis, the Soviet Union, came out with it hands up, begging gimme, gimme. Defence spending, for the first time in human history could take a more appropriate place in the economic landscape.

Hark to me!

There is no upside left - only some very sizeable potential bananaskins. What if there is a revolution in Kuwait or Saudi Arabia?, for example, that would be good for a 50% crash. What if the Soviet Union returned to its old ways? What if the Chinese seize Taiwan? And the Middle East, well?!

I am not referring to Nuclear Catastrophe here, we'll all go together if that happens! I am pointing out that we are at an unprecedented peak in human economic development and geo-political stability. The next seismic shift will surely be south! Hark to me!
Sea Pigeon was taken to the knackers' yard for such pessimism.

What has happenned in New York is utterly cataclysmic.

There are broadly three possibilities for equity markets looking forward:

1) WWIII this has no impact on the values of equities as everything will be worth nothing then.

2) International co-operation against terrorism. This is probably the current basis of equity pricing and certainly justifies current write downs.

3) American isolationism and aggressive attacks against Islam. This is disastrous for equites and Irish equities in particular.
 
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Joe Public

Guest
Re: Cult of Equities

I know this discussion has gone off in other directions since the last post, but there's an interesting update in today's Financial Times.
 

Brendan Burgess

Founder
Messages
38,108
Re: Cult of Equities

Here are some extracts from the article:



The latest London Business School study of long-term returns found that more than a quarter of equities' historical outperformance can be explained by an increase in share valuations (rather than by the underlying performance of the corporate sector).

...the performance of bonds may have been artificially depressed by the inflationary 1970s and 1980s.

... This is already the case with some UK pension funds, which have switched to bonds as they struggle to comply with the new accountancy standard FRS17.

More than a quarter of equities' outperformance can be explained by an increase in share valuations? That's not a lot

the performance of bonds may have been artificiallydepressed? Why was it artificial?

I think that the final quoted paragraph is too simpistic an interpretation of FRS 17.

Brendan
 
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