Article / 04 February 2016 at 14:00 GMT

How equities can make for blockbuster long-term returns

  • Bundesbank has calculated astonishingly high returns for stock investments
  • Looking at two indices over 25 years gives a sense of what's possible
  • Return rates highly varied over short and long terms
  • Average annual rates of return above 8% do not seem unrealistic
  • Investing in stocks is never a safe bet , even in the longer run
Bundesbank
Does this building look familiar to you - It is the HQ of the German Central Bank, 
this time seen from the South, but still without people. Photo: Bundesbank

By Clemens Bomsdorf

A real annual return of over 8%! That’s something many private investors only can dream of, particularly if this is not merely a one-time result, but is achieved in the longer run. Nevertheless, this high number mirrors what German savers made in the last 24 years with their equities, says a Bundesbank study (for more on savings, see my previous article).

This is an astonishing performance, in my view, and requires further investigation. After all, the 24 years examined by the Bundesbank's survey could quite easily have been an extraordinary period, or perhaps the investments chosen for some reason performed abnormally well... 

Challenging the German Central Bank

The Bundesbank did not restrict its enquiry to one index but looked at many, weighting them so as to establish that "financial accounts indeed do provide the average equity portfolio of German households" (as they stated in an email to me; more details on the calculation can be found at the end of this previous article).

Though it was interesting to hear about what sort of real returns German households averaged with their stock portfolios, we will now present a more easily reproducible calculation and look separately at two major indices so as to show how they performed over different periods of time. 

Our point of departure, of course, is a Bundesbank study and since Germany is the Eurozone’s largest economy, taking the Dax’s performance as one example makes perfect sense. After all, it is a popular investment vehicle of many Germans and non-Germans alike, and thus a likely target for savings.

For a broader perspective, we will also look at the the Eurostoxx...

Eurostoxx
To make things as transparent as possible, we will first look at nominal return rates as these are the ones published by stock exchanges and therefore the most accessible. As we are speaking about savings here, compound interest is taken into account – i. e. performances are calculated as if financial gains are only realised at the end of the period, and dividends are reinvested. 

Also note that the average rates of return presented assume a one-time investment at the start of the period with divestment occuring only at the end; no changes to the portfolio are made in the intervening period (not even additional funds invested in the same index). 

This is not typical savers' behaviour, as people ordinarily put aside smaller sums regularly, but such calculations are easier to understand and reproduce, and therefore represent a good starting point.

Lottery
Lottery winnings are rare, but would be a good one time investment. Photo: iStock 

The Dax is usually calculated as a total return index while the Eurostoxx is not. Below, both are presented as total return indices, mirroring performance under the assumption of reinvested dividends (investment costs are not taken into account, but for the case of the Dax, German capital gains taxes are).

Frankfurt based Deutsches Aktieninstitut, an association trying to make savers more aware of the possibilities represented by equity investments, annually publishes its so-called "return triangles", which depicts the average performance of stock investments over time.

Quarter-century returns tend to be far above 5% – or at least they were...

Choosing the year of purchase on the right axis and the year of sale (both are year-end dates) on the lower one, one finds the rate of annual average return by drawing lines from these two dates and letting them meet. 

Hence, as already mentioned a one-time only investment is what is under consideration here. In order to be able to read the Eurostoxx and Dax illustrations below, you might want to click to enlarge.

Eurostoxx Return Triangle (click to enlarge)
Eurostoxx Return Triangle

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Source: Deutsches Aktieninstitut
 
According to the return triangle above, an investment into the Eurostoxx covering the same 24-year period as discussed in my previous articles (start of 1991 until end of 2014) led to an average annual return of 8.5% (NB: since the DAI calculates investments at the end of the year, 1990 has to be chosen as the year of purchase and 2014 the year of sale).

This is quite close to the real average annual rate calculated by the Bundesbank (based on a different portfolio) for the 24 years ending in 2014. 

Buying stocks is never a safe bet

We will calculate real rates in an upcoming article; now we will only take a look at different investment periods as well as the Dax. 

As mentioned earlier, 24 years is kind of an awkward period since people tend to think and calculate in five-year steps, so now we will switch to investigating that period (the difference is not that large in terms of the average rate in most cases).  

horse race
Buying stocks is never a safe bet, but it's probably less risky 
than betting on horses. Photo: iStock
 
Twenty-five year periods for the Eurostoxx lead to average annual total return rates between 6.5% and 8.6% (for the investment periods 1986-2011 and 1987-2012, respectively). The latest 25-period ending last day of 2015 led to a average annual return of 8.5%.

Average annual rates of return are most diverse for shorter periods. The most extreme cases, of course, can be found when looking at holding the Eurostoxx equities for one year only. 

From losing 42.3% a year...

Buying at the end of 2007 and selling a year later led to a negative performance of 42.3% as this period represents the year of the last big crash. The other extreme is an investment undertaken at the end of 1998 and sold a year later – the return in that case was 48.6%. 

Those that bought when the downturn started (end of 1999) only saw their investment's achieve having a positive average annual rate of return again in 2015, and even then it was only 0.1%, so one can imagine that after the recent turmoil (the Eurostoxx lost more than 10% since the start of this year), the average annual rate turned red again, declining further still when looking at real rates. Buying stocks is never a safe bet.

Dax return triangle (click to enlarge):

Dax Return Triangle
 
The return triangle for the Dax is much more comprehensive and covers the period from 1966 until 2015. It is only available in German, but the concept is the same as for the Eurostoxx return triangle, so one can read it without understanding German.

Because the Dax did not exist for the first decades under discussion, it has been calculated for the years prior to end of 1987 (see wiwi.hu-berlin.de/finance and this for further discussion of this point).

...to gaining 84.1% during one year

Here investments made and kept over 25 years led to an average annual total return rate of between 5.4% (for the period 1986-2011) and 13.5 % (for the period 1974-1999). 

stormy
Ups and Downs are largest in the very short run. Photo: iStock 

The worst annual return of minus 43.9% was made when buying at the end of 2001 and selling a year later. The highest positive annual return was 84.1%, and was reached in 1984/1985. For the period covered by the Bundesbank survey, the average rate of return was 7%.

What we can see is no big surprise: Nominal rates of return differ largely from year to year and even over periods of 25 years, the difference can be huge. 

Just to make savers and investors more aware of what that means, the charts below show selected return rates applied over 25-year periods. We choose the best and worst average return rate over 25 years for the Dax and Eurostoxx, as well as the 1% and 8% from the previous article. 

One can easily see what a relatively large impact little rate changes (compare 8% with 8.6%) can have over time. 

25 years


The tremendous effects of an extraordinary, 13.5% average return rate (as the Dax reached averaged annually from the end of 1974 to the end of 1999) makes even other solid results appear paltry. It is therefore only included in the second chart.

25 years extra
 
Another thing to consider is that inflation varied a lot over the years. In an upcoming article, we will therefore look at its impact and calculate real rates of return with this variable accounted for.

For the time being, it is enough to have another look at the return triangles and charts and become aware of that long-term investments are usually built over time, rather than with a single initial purchase. 

Money is not ordinarily invested in a single year, but rather over a longer savings period (often 25 years or more); as such, the volatility in nominal rates is even lower for the whole investment.

Concrete Jungle
Concrete Triangle Jungle: this is what you get when calculating 
Bob Marley + Brutalist Architecture + return triangles. Photo: iStock

— Edited by Michael McKenna

Clemens Bomsdorf is a consulting editor at TradingFloor.com

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