Tuesday, October 28, 2008

What actually happens in the long run?

I recently posted that bottom-up and value-oriented investors tend to be bullish on the US equities but noted that top-down investors continued to be concerned about the macro environment.

There are exceptions. Here is a top-down analysis that concluded that equities are cheap. Based on Jeremy Siegel’s observation that stocks have historically returned about 7% a year, the authors of this study showed that currently equities are trading well below the 7% trendline and concluded that stocks are cheap.

This is an example of an analysis whose data suffers from a severe problem of survivorship bias.

Survivorship bias colors the data
What if your family had managed to save the equivalent of $100 at the time of Augustus Caesar (give or take 2,000 years ago) and put it into equities or an equivalent investment? At 7% a year, the value of your family’s $100 original investment would now have 60 zeros behind it. Your family could finance TARP and the bailout by the world’s central banks from the chump change derived one day’s interest.

What happened?

What happened was in the intervening 2,000 years, there were many upheavals that destroyed wealth. Empires fell, starting with the Roman Empire, barbarians sacked cities and a lot of people died in very unpleasant ways.

We don’t have to go back 2,000 years to look at survivorship bias or wealth destruction. Going back 100 years, people mainly invested in bonds and equities did not represent a liquid asset class. Supposing we were to look at the bond markets 100 years ago, the “developed” market consisted of Britain, France and Germany. The “emerging” markets were America, Argentina, Canada and Russia. (Please forgive me if I have forgotten a market or two.)

Any analysis of the capital markets today that focuses on the principal survivor markets (US and UK) would have missed a number of markets that tanked horribly during that 100 year investment interval. Any care for some Argentinean railway bonds from 100 years ago? Russian ones? How about some “safer” German bonds? After all, it was a developed market - which subsequently went through one world war, subsequent hyperinflation and then the physical devastation of its infrastructure after another world war.

War and revolution the risk
Today, people are cranky and getting crankier. The risks of political turmoil are front and center. The gentlest example I have is a chart of the electoral map before and after the Great Depression. We could very well see the trend favoring open markets and the free flow of capital and ideas reverse itself. War is a possibility.

Think about your assumptions
This is a warning for quants and other modelers. Think about your assumptions to avoid making fundamental errors in judgment.

Bottom-up investors are finding bargains today. Top-down investors continue to be worried about the macro risk of a sea change that may devastate their wealth just as some of the events in the past hundred years have destroyed wealth. Were it not for those very real concerns, equity prices would probably be a lot higher than they are today.


Unknown said...

great post. Survivorship bias in one's own home market is very common. The equity premium is a lot less than people think when looking at a historical sample of more than one.

Wesley R. Gray said...

We think the same!

Johan Lindén said...

I very good post! Obviously more than 90% av analytics haven't understood this concept!

I will bookmark this site and send that post over to friends!

Thanks a lot for sharing great wisdom!

ac said...

cash flows from the distant future is not worth a whole lot now.

2000 years in the past, 2000 years in the future is completely irrelevant with respect to valuation

Ross said...

Great post. I suggest reading Barton Bigg's Wealth, War & Wisdom which goes into depth examining the global wealth destruction of the Depression to WWII era.