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Build a future-orientated portfolio using history as your teacher

South Africans had little choice but to invest in the local stock exchange, artificially boosting performance.

Our last two articles for Moneyweb focused on designing an appropriate retirement portfolio, tweaking when necessary.

Read: Five tips for the ideal long-term portfolio

Read: Dealing with portfolio headwinds. When do you panic?

This article underlines the importance of diversification and building a future-orientated portfolio.

In their book ‘Triumph of the Optimists; 101 Years of Global Investment Returns’[1], three professors at the London Business School, Elroy Dimson, Paul Marsh and Mike Staunton, analysed the performance of equities and bonds in 16 countries between 1900 and 2001. It provides a wonderful historic record and tracks post-inflation equity, bond and money market returns/cash (called ‘bills’) in 16 countries over 101 years.

The research was subsequently updated by the authors, partnered by Credit Suisse. The graph below (with data to 2013) shows the returns of 23 countries (7 more than in the original research), as well as the world average, the ‘world excluding the US’ and the ‘old world’.

Real annualised returns (%) on equities versus bonds and bills in selected countries, 1900 to 2013

Source: Credit Suisse Global Investment Returns Yearbook[2]

This graph above shows that while handsome profits can be made, political turmoil and war can destroy wealth. It should be stressed that the research ignores a wide range of contributing factors to the outperformance of some countries, such as tax or exchange rates controls.

One reason for South Africa’s relative outperformance for the past 100 years was that it is a commodity-rich country, but another is that between 1970 and 1994, strict exchange controls were in place. South Africans had little choice but to invest in the local stock exchange, artificially boosting performance.

It is illustrative to wind back the clock and put yourself in the mental framework of an investor in 1900. Consider the following:

  • Austria’s stock exchange was established in 1818, and in 1900 was the second largest country in Europe with 5% of the world’s market capitalisation. It would certainly have been worthy of fund manager interest. And yet, between 1900 and 2013 annualised equity return, including dividends, was 0.8%.

  • Belgium, geographically well positioned to take advantage of trade opportunities across Europe, had a flourishing financial sector. However it was to suffer enormous losses during WW I and WW 2 and has never regained its eminent financial status.

  • In 1900, China was experiencing the last decade of the Qing Dynasty; it became the Republic of China (ROC) in 1911. The ROC nationalists lost control of the mainland at the end of the 1946–49 civil wars after which their jurisdiction was limited to Taiwan and a few islands. The communist takeover in 1949 generated total losses for local investors, including estimated equity returns as seen in the graph.

    In 1900, a French, Greek or Italian investor would have considered an investment in Australia or South Africa as ‘alternative’ and therefore more risky than investing in say Austria with its 72 year old track record.

    A common factor among the best-performing equity markets over the last 113 years is that they have been resource-rich and/or New World countries. It is uncertain whether this trend will hold as the world enters a new phase, where the technology, artificial intelligence, media and/or bio-tech sectors might be the winners of the next 100 years.

    So where does this leave us?

  • Portfolios should be carefully structured to take advantage of long term equity risk premia, as history teaches us equities outperform over time.

  • Be well diversified; investors should not be invested too heavily in either a single country or a single sector. We favour a ‘core satellite’ approach for an investment portfolio, which sets out guidelines for allocation to different asset classes and specialist mandates, and yet is structured in a way that makes it easy to up-weight or down-weight more opportunistic satellite portfolios.

  • Look to the future, not to the past. Fund managers should be mandated to look for value, which could be opportunities in the US healthcare and pharmaceutical sector (to take advantage of aging boomers), or the Indian tech/e-commerce sector (to take advantage of the increasing middle class) or emerging markets (avoiding over exposure to SOE’s, heavy industry and resource counters that dominate most EM indices).

[1] Source: Elroy Dimson, Paul Marsh, and Mike Staunton, Triumph of the Optimists, Princeton University Press, 2002, and subsequent research


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