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Wednesday, 13 February, 2002, 12:26 GMT
Investors face 21st century gloom
Frankfurt trader dressing up for the carnival, 12 February 2002
Taking a historic perspective on share prices
By BBC News Online's Jorn Madslien

Ever since World War Two, the stock market has offered the best returns on investment.

Tobacco has always been a traditionally defensive stock because people have got the habit, and even when times are bad they'll puff away

Professor Paul Marsh
London Business School
But in the wake of recent sharp falls in global share prices, many investors have begun searching for alternatives.

However, equities are still worth a punt provided shareholders are prepared to accept that the era of spectacular short-term gains is over, according to a new report from a group of academics at London Business School.

"You're still to invest in equities, but you should only embark on that path if you have a relatively long time horizon," Professor Paul Marsh told BBC News Online.

Heyday over

And, he added, shareholders should also prepare themselves for a decline in average long term returns compared with the levels seen over the last half century.

"The last 50 years were too good to be true," Professor Marsh insisted, pointing out that "equities are not a sure thing".

Frankfurt trader dressing up for the carnival, 12 February 2002
Is the party over?
Of course, all investors know that the value of their investments can go down as well as up.

But Professor Marsh and his colleagues, Professor Elroy Dimson and Dr Mike Staunton, believe that the time has come for shareholders to fundamentally revise their expectations downwards.

"Investors should expect a smaller reward from investing in equities," the academics warned.

Post-War boom

In 1945, nobody knew that the stock markets would soar over the next few decades.

In fact, "investors did much better than anyone could have expected", Professor Marsh said, describing the era as "the triumph of the optimist".

Similarly, one would have thought that nobody quite knows what is going to happen over the next half a century.

So what are the academic trio's downbeat forecasts for the next century based on?

Risk and reward

Like most forecasters, Professor Marsh and his colleagues have based their predictions on a study of the past.

Frankfurt trader dressing up for the carnival, 12 February 2002
Can you trust the stock markets to deliver good news?
They found that it has become far less risky to invest in shares than it used to be, in part because it has become much easier to spread the risk.

Innovative financial instruments and growing market participation have made it much easier to diversify between companies, sectors or even countries, Professor Marsh explained.

International trade flows have increased, and with the end of the Cold War, political risks have been greatly reduced.

The decline in investment risks pushed share prices higher during the last century; investors were prepared to pay more given that the risks were reduced.

In addition, productivity growth, accelerating technological change, and improved management and corporate governance boosted corporate cash flow much faster than anyone expected, the report said.

"This higher growth is now known to the market and built into higher prices," the report said.


So whereas during the last century, investors were repeatedly caught on the hop by higher than expected growth, this is unlikely to happen again, according to Professor Marsh.

For one thing, technological leaps no longer surprise investors as much as they used to.

And the unexpected disappearance of long-term political risks is unlikely to recur on the same scale as it did last century.

With most investors holding far more diversified portfolios, stock markets are now much less vulnerable to external shocks.

But most importantly, said Professor Marsh, one "can't expect to keep having massive good surprises".

"Rationally, one can only predict that prices will reflect a balance of good and bad surprises".

Better than cash

Taking all these factors into account, Professor Marsh and his colleagues have calculated that the equity "risk premium" - the difference between higher returns on risky shares, and lower returns on safe bonds - is due to decline.

They have calculated that the difference in returns between shares and bonds during most of the last century stood at about 5%.

During the next few decades, they believe the premium will fall to 3%.

This means that an investors should expect to get a 3% higher return on a share investment to compensate for the greater risk of holding shares compared to bonds.

Consequently, shares will still offer the best returns on investment over the long term, but their superiority over bonds will diminish, explained Professor Marsh.

Safe tobacco

But there could still be turbulence along the way.

Take the UK telecoms and the technology sectors; here investors have been hit by an 85% fall in share prices since March 2000, Professor Marsh pointed out.

Shares in the tobacco industry, on the other hand, has gained 47% during the same period.

"Tobacco has always done well," Professor Marsh noted.

"Tobacco has always been a traditionally defensive stock because people have got the habit, and even when times are bad they'll puff away".

See also:

19 Dec 01 | Business
Dow signals US recovery
11 Sep 01 | Business
Market turmoil after US attacks
01 Jan 01 | Business
Which way for shares in 2001?
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