Absolute Return Investing Part 1: The odds of making money in different Asset Classes
"What are the odds Ray?"
Intro
Some may remember Stan Druckenmiller’s interview last year, where he casually mentioned never having a losing year for several decades. So it got me thinking: what are the chances of someone with zero edge/expertise in markets (like Riley in a prior post) of delivering Absolute Returns? Meaning no losses on an annual basis.
Now you’re probably wondering “what’s Ray Winstone from the Bet365 advert is doing as the picture?” Well aside from the usual finance stuff, I’m going to quote Ray’s odds of losing money in different Asset Classes, to make it really clear what chances you’ve got (e.g. “1 in 4 chance of losing money in stocks in a typical year”).
Methodology
This gets pretty complex, so feel free to skip on to the Results.
I got hold of longest time series possible from various sources. We’ve got 150 years (1870-2020) for all but one asset class, which I don’t think is bad effort for a weekend project.
Stocks, Government Bonds and Housing Total Returns (capital appreciation + dividends/coupons/rent) = MacroHistory covering 16 countries (Developed Markets incl. USA, UK, Germany, Japan etc) (note 1)
The stocks are indices (e.g. S&P 500), the government bonds typically 10 year maturity and sometimes longer. Whilst the housing series are national averages.
For example we have roughly 150 years * 16 countries = 2,400 yearly returns. I then work out % of these which were negative, to calculate the odds of losing money in a typical year. This ensures the research isn’t U.S centric/more representative of the global asset class.
Corporate Bonds = The shortest series with only 101 years of data covering 1920-2020 from The Federal Reserve Database on AAA and BAA bonds (note 2).
Gold = National Mining Association and World Gold Council (note 3).
Note 1: Some countries have slightly less than 150 years (e.g. 140 years). I felt it better to add 140 observations to the data rather than leave these countries out, as we’re trying to model asset price behaviour at an aggregate level rather than between countries. Also having looked at each country individually, they all paint the same picture/similar amount of positive years.
Note 2: As the Moody’s indices use bonds with 20 year maturities, I therefore a) work out the yearly duration based on this b) account for defaults using Moody’s Corporate Default and Recovery Rates Study c) assume 40% recovery rates given this is the norm in most academic papers and books I have read.
Note 3: Gold Prices have been fixed from time to time throughout the period, thereby increasing the amount of non-negative return years artificially. I still felt it worth including and you’ll hopefully see why in the results.
Results
Bonds are the way to go
If you’re looking for positive returns year in year out, bonds are the way to go. Yes housing looks more attractive, though it’s hard to invest in at an aggregate level unlike stocks or bonds. So Ray’s 1 in 6 odds of losing money in a typical year for government bonds/the safest Asset Class outside cash, makes you realise how tough Absolute Returns are to deliver over a lifetime. So Stan’s record looks even more impressive given the evidence.
Commodities are for trading, not holding
You’ll notice that the 2 Asset Classes with the lowest % of positive yearly returns were both commodities. It seems like Gold (the thing that supposedly holds its value) is no better at preserving capital than stocks or bonds. Because I didn’t believe this initially, I also ran the % of negative years for just 1970-2020 for Gold, when it wasn’t fixed and had high inflation to help it - still only 65% of years it went up, see chart below.
So can you make Absolute Returns in commodities? Yes, though you basically have to nail market timing year in year out and trade it. Unlike the other asset classes which you can buy and hold for several years, as they have a better structural long bias (e.g. 8 in 10 years you’ll make money in AAA corporate bonds).
Recommendations to Investors
Ask to see Asset Allocations
This advice is as applicable to retail investors as institutional ones. If a wealth/fund manager is committing to Absolute Returns (often implied by a cash + or CPI + benchmark), do ask for the asset allocation. If you see the majority isn’t in bonds or a sizeable amount is in commodities, it’s probably a good idea to spend a few sessions with them, to truly understand if they have an edge or not. Otherwise, the odds of them beating that benchmark year in year out are challenging.
Pause before shorting
I know it makes headlines when people make lots of money during market drops, though it really isn’t a fight worth taking unless you have serious conviction or a significant edge. Because you’ve got a 1 in 4 chance of being right betting against stocks, and even worse odds against bonds. On the other hand you do have a better chance shorting Commodities, however that’s a dangerous game given how volatile they can be (see Nat Gas).
So next time you think the world is ending/stock market will fall because some guy with 8,000 years experience says it’s going to (no references needed). Please do remember human being’s have been going several hundred thousand years and we do normally find a way through things, meaning businesses and governments continue to function and make money for investors.
Hope you learnt something new, Part 2 will focus on how to increase the odds of making money both long/short
Chris