Why Invest in Equity Markets

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Investors should invest for the long-term and should not try to time the markets. This is especially important for retail investors who lack the time, effort and information necessary to trade for short-term gains. Even most professional money managers with access to powerful tools and better information rarely perform better than the benchmarks.

Equity markets do not always go up in a straight line in any country. There will be bull markets followed be bear markets and the cycle will continue. The following chart shows the performance of the MSCI World Index from 1970 to 2001:

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Source: Why Stock Market Investment?, Royal Skandia

The number of bull markets far exceeds the number of bear markets as shown in the chart above. In addition, the gains produced during bull markets far exceed the losses produced in down markets. Hence investors that stay invested for the long-term get rewarded well for their patience.

For example, though U.S. stocks had a lost decade from Dec 31, 1999 through Dec. 14, 2009 with the S&P 500 losing 23%, smart investors who invested in dividend stocks would have better returns. Choosing stocks with yields of about 3% would have produced a decent return in the “lost decade” due to the effect of dividend reinvestment and compounding.

From a recent article on UK stocks:

For instance, looking at the past 14 years, it could be argued that the FTSE 100 has delivered zero capital returns, with the index being at exactly the same level as it was in February 1998.

The only return, apparently, is from dividends of around 3-4% per annum, which when compounded gives a total return of around 70% over the period.

Hence though the overall stock market goes nowhere during a specific period, investors can still do well by building a portfolio of high-quality dividend stocks and reinvesting the dividends.

Ten foreign stocks to hold for the long-term are listed below with their current dividend yields:

1.Company: Empresa Nacional de Electricidad SA (EOC)
Current Dividend Yield: 3.31%
Sector: Electric Utilities
Country:Chile

2.Company: DBS Group Holdings Ltd (DBSDY)
Current Dividend Yield: 5.75%
Sector:Banking
Country: Singapore

3.Company: Administradora de Fondos de Pensiones Provida SA (PVD)
Current Dividend Yield: 6.43%
Sector: Investment Services
Country: Chile

4.Company: Toronto Dominion Bank (TD)
Current Dividend Yield: 3.76%
Sector: Banking
Country: Canada

5.Company: National Grid PLC (NGG)
Current Dividend Yield: 5.52%
Sector: Electric Utilities
Country: UK

6.Company: Telefonica SA (TEF)
Current Dividend Yield: 9.82%
Sector: Telecom
Country: Spain

7.Company: Banco do Brasil SA (BDORY)
Current Dividend Yield: 4.08%
Sector: Banking
Country: Brazil

8.Company:Cpfl Energia SA (CPL)
Current Dividend Yield: 6.44%
Sector:Electric Utilities
Country: Brazil

9.Company: Australia and New Zealand Banking Group Ltd (ANZBY)
Current Dividend Yield: 5.45%
Sector: Banking
Country: Australia

10.Company:EDP Energias de Portugal SA (EDPFY)
Current Dividend Yield: 8.53%
Sector:Electric Utilities
Country: Portugal

Note: Dividend yields are as of Oct 19, 2012

Disclosure: Long TD

Why Volatility Also Matters

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Diversification of assets is an prudent way to reduce risk in a portfolio. While the concept of diversification is important volatility is another factor that investors should focus on to generate higher returns.

Why does volatility matter?

The table shows the performance of two sample portfolios with both having an initial investment of $1.0 million:

[TABLE=1144]

Both the portfolios have an average return of 0% in two years. However Portfolio 1’s value at the end of 2nd year is only $750,000 while Portfolio 2 lost only $10,000 and has a value of $990,000. The reason for the difference in performance is that Portfolio 1 is much more volatile. Portfolio 2’s lower volatility produces a higher compounded return.

So the key takeaway from this post is that if two portfolios have the same average return then the portfolio with the lower volatility will always have the higher end value.

Source: Why Volatility & Diversification Matters, Stewart Partners, Australia

Volatility in a portfolio can be minimized by avoiding highly volatile stocks such as IPOs, internet sector stocks, biotech stocks, penny stocks, etc.

Relative Size of World Stock Markets, end-1899 and end-2011

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Here is an interesting chart showing the share of world stock markets at the end of 19th century and last year:

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The size of the stock markets of France and the UK declined significantly in the period shown due to both the countries losing their status as world superpowers. However the U.S. became a major global player with its stock market rising from under 20% at the end of 1899 to about 45% of the world market size at the end of last year. From the Credit Suisse YearBook:

The New York Stock Exchange traces its origins back to 1792. At that time, the Dutch and UK stock markets were already early 200 and 100 years old, respectively. Thus, in just a little over 200 years, the USA has gone from zero to a 45% share of the world’s equity markets.

Source: Credit Suisse Global Investment Returns Yearbook 2012,  Credit Suisse

Comparison of Real Equity Returns over a Century Between US, UK and Italy

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Equities beat other asset classes such as bonds and short-term deposits over the long-term.Stocks not only yield higher returns than those asset classes but also yield higher returns on an inflation-adjusted basis.

The following graphs for three developed markets over the course of a century proves this point:

Real Equity Returns in US (top), UK (middle) and Italy (bottom), 1900 – 2002

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Source: Triumph of the Optimists,  by Elroy Dimson, Ph.D. Professor, London Business School, October 2003,  ArrowStreet Capital, L.P.

Related ETFs:

SPDR S&P 500 ETF (SPY)

iShares MSCI United Kingdom Index (EWU)

iShares MSCI Italy Index (EWI)

Disclosure: No Positions