Irrational optimism

Finance

IFA Working Paper

Dimson E;Marsh P R;Staunton M

Paul Marsh Elroy Dimson

2003

We examine the widely held belief that stocks are a “safe” investment for the long run. The probability of experiencing a real loss on equities depends on the expected real return and standard deviation of stocks. Judgments about the future magnitude of these two parameters typically involve extrapolating from history. We use a global database of real equity returns from 16 countries during the 103-year period from 1900 through 2002 to confront the optimism of investors with the reality of history. We find only three non-US equity markets (with a fourth on the borderline) that never experience a shortfall in real returns over a 20-year period. The worst 20-year real returns of 11 countries were negative. Historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return. We also analyze the future shortfall risk of an equity portfolio. Stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investor. Prospective returns are lower than many investors project, whereas risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational.

Institute of Finance and Accounting

FIN 397

IFA Working Paper

No

View document