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Elroy Dimson: learning from history

May 08, 2014
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Here at Sensible Investing, we’re always emphasising the importance of stock market history, and few people understand this subject better than Elroy Dimson. As well as being Emeritus Professor of Finance at London Business School and Visiting Professor at Cambridge Judge Business School, he also chairs the Strategy Council for the Norwegian Government Pension Scheme and co-directs the Endowment Institute at Yale School of Management. But Professor Dimson is possibly best known for editing the Credit Suisse Global Investment Returns Yearbook, which contains data spanning 114 years of history across 25 countries.

SITV: In a general sense, how can investors learn from market history?

Elroy Dimson: One of the problems investors face is that they learn too much from recent experience. So, at the end of the 1990s, investors knew that shares would always go up. By the end of the 2000s they knew that shares are a bad idea. People learn too much from the last 10 or 20 years they’ve gone through. What the historian can do is to enable them to learn from the critical decade that their parents had, or their grandparents had, or great-grandparents. There’s a lot to learn from looking at the long-term to avoid being influenced by the very recent past.

SITV: It does seem that since, say, the Asian crash in 1997, we’ve had to contend with higher-than-average volatility. Is that actually true?

Elroy Dimson: We have seen more than our fair share of crashes in recent memory. But is the market any more uncertain than it ever was before? The jury is out on that. One way we can look at the volatility is to study the VIX Index, sometimes known as the Fear and Greed Index, which measures how volatile US securities are. The current level of the VIX is below the long-term average. The prices that investors are setting today do not anticipate a level of volatility that’s unusually high. If anything, it’s lower.

SITV: All investors would do things differently with the benefit of hindsight. But trying to time the market is never easy, is it?

Elroy Dimson: Any investor who has the choice should always go for having very good foresight, because hindsight is misleading! When we look back in time, we can see when shares looked expensive and we should have got out, and when shares looked cheap and we should have got in. But at any particular point in the past, we only have data that’s available at that time, and that makes it very much more difficult to determine when’s a good time to invest. So the mantra we should share is the importance of time in the market rather than timing the market. Time in the market enables you to take a long-term perspective and to reap rewards if you’re in there long enough. Timing the market means you may avoid the bad times, but you may get out of an asset class just when it’s about to do well.

SITV: What does history tell us about the importance of diversification?

Elroy Dimson: Not only can companies lose all or much of their value, but sometimes even complete markets can do that. Spreading your money across different geographies and different asset classes reduces the extremes that you can suffer. The price you’ll pay for that, of course, is that you won’t have the extremes on the upside. You’ll get an average return - but an average return that reduces the chance of financial catastrophe. It is true that the correlations between markets during the credit crunch were higher than in the crises we saw in earlier times. The benefits of diversification are not as great as they were, but they’re still there for the taking, and they’re well worth taking advantage of.

SITV: Why do market bubbles keep recurring?

Elroy Dimson: What we teach our students in their very first finance class is that the value of an investment is equal to the prospective dividend that we’re going to get from our investment, divided by the difference between the return that we expect and the growth rate of those dividends. In a period of investor enthusiasm, risks seem low, and so we don’t require a very large return; and we’re also expecting very large growth rates. So at times when the market has gone up - say, at the end of the 1990s - investors are taking prospective dividends and they’re discounting those at a gap between a required rate of return that’s low and a growth rate’s that large, and that’s quite fragile. The more confident people feel about the future, the more a tiny nudge in perceived risk or prospective growth rates can seriously knock it down. That’s the most dangerous time. And at times when people are feeling gloomy, after a bubble has burst, it’s less fragile.

SITV: Generally speaking, does history tell us that investing in equities is a good idea?

Elroy Dimson: It tells you that although over certain periods you can fail to be rewarded for investing in equities, over the very long term equities have given a return of 4% over what you would have got from holding cash and about 3% above what you would have got from government bonds. That’s worth having. Compound interest has a big impact. So if you’re an investor for the long term, small periods of superior performance can add up. And in today’s world, where real interest rates are so low, the long-term performance of a portfolio will be determined by the reward one receives from exposure to equity-type risk. Given today’s more modest expectations of a reward for stock market risk, paying large amounts by way of fees is something that one should do with great caution. I would not advise that people should only ever go passive, but I would always argue that you should look at the hidden and explicit costs involved, and identify how much of the expected reward is actually being spent on fees, commissions and other drags on eventual performance.

SITV: Finally, what do you think is the best sort of investment?

Elroy Dimson: One of the conclusions one reaches nowadays, when rewards are so difficult to find, is that one has to chase after the safest investment there is. I would say this, wouldn’t I? But education is a safe investment. So if I’ve learned anything it’s that you should invest in an education for oneself and one’s family before investing in the hope of becoming just financially rich.

Professor Dimson is one of the main contributors to our highly-acclaimed video series Stock Market History: A Crash Course for investors. The series is in eight parts, and if you haven’t watched it yet, please do. We’d be very interested to receive your comments and opinions.


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