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In the book "Triumph Of The Optimists: 101 Years Of Global Investment Returns" (2002), Elroy Dimson, Paul Marsh and Mike Staunton offer the most complete study of historical global market returns. The book documents market returns for 16 countries from 1900 to 2000. From this research, it is evident that three important changes took place in the global stock market in the last century: the United States achieved market dominance; the exchanges were consolidated; and secular sector rotation occurred. Unfortunately, understanding the past doesn't necessarily make predicting the markets' future any easier. Let's look at what happened in the past century and why some experts say history may not be destined to repeat itself.

To the Winner Go the Spoils
Unfortunately, until "Triumph Of The Optimists" was published, most of the available historical stock market data for the years prior to 1970 was only for the U.S. market. This isn't surprising, since the U.S. stock market was the big winner of the twentieth century. Its weighting increased to 47% of the world's total and, in general, it performed more favorably than the rest of the world's markets. This occurred for a number of reasons, but chief among them were larger investments in physical and human capital, greater technological advancement and greater productivity growth. With its huge investment demand and technological superiority, the U.S. investment industry was a worldwide leader. (To learn more, see What Are Economies Of Scale?)

Other countries have lesser-known histories. For example, it took the United Kingdom much longer to recover from the world wars. Its diminished role after the collapse of the British Empire and the complicated bureaucracies of the colonial system slowed the United Kingdom's growth immeasurably. According to the authors, problems with defense spending, labor, productivity and investment plagued the British economy and markets until the mid-1970s.

The United States, on the other hand, suffered relatively little disruption to its stock market during the world wars and didn't have the prolonged declines that many of the European and Asian markets experienced. In fact, the United States' economy largely benefited from the wars - successful companies such as General Motors and IBM thrived as a result. At the same time, many other economies suffered great losses. For example, according to Phillipe Jorion and William N. Goetzmann in their article "Global Stock Markets In The Twentieth Century" (1999), the Japanese stock market saw a 95% decline in real returns between 1944 and 1949. The German market also suffered devastating losses. In this context, the U.S. market's success seems to be an exception, which the previous lack of data for other countries may have obscured.

Past Success and Future Performance
Many valuable lessons can be learned from history, but extrapolating historical returns into the future is difficult and complicated. For instance, few investors in 1900 could have predicted the monumental changes that would take place in the world after 1913. The two world wars, socialist revolutions, the Great Depression and the Bretton Woods Agreement all had a profound impact on the global economy and stock markets until the 1970s. The impact of these events suggests that although we can study the past, the social and economic events that might affect the markets in the future are often unpredictable. (For more insight, see Dollarization Explained and What Is the International Monetary Fund?)

Furthermore, despite the clear success of the U.S. markets since 1900, investors need to remember that this exceptional performance may be just that: the exception, rather than the rule for the twentieth century. "Triumph of the Optimists" argues that economic and stock market performance in the United States has not been typical of other countries and, therefore, should not necessarily be extrapolated into the future.

The graphs below show a breakdown of the world markets in both 1900 and 2000 and the anomalous growth of the U.S. market during this time.

Globalization and Consolidation
The stock markets of 1900 had more regional exchanges than those of today. For example, Dimson, Marsh and Staunton state that the United States and United Kingdom each had 20 to 30 different regional exchanges. Most of these exchanges - such as the Los Angeles Oil Exchange, which dealt with the petroleum industry - focused on the industries prevalent in their areas.

The difference between the number of exchanges in the early twentieth century and the number that exists today is due mostly to advancements in telecommunications and innovation within financial markets. In "Globalization Myths" (1996), Paul Bairoch and Richard Kozul-Wright describe how, between 1930 and 1990, the cost of a three-minute telephone call from New York to London dropped from $245 to $3. Advancements like these have propelled the globalization of our economy and its financial markets. Today, New York, London and Tokyo are widely regarded as the world's financial centers, and technological advances have allowed them to be interconnected despite the distance between them. As a result, the twenty-first century global economy is defined by financial centers rather than smaller regional exchanges. (To read more, check out Getting To Know Stock Exchanges and The Tale Of Two Exchanges: NYSE And Nasdaq.)

Sector Rotation Like You Have Never Seen Before
Many investors today focus on short-term sector rotation to add value to their portfolios. According to Dimson, Marsh and Staunton's research, this type of rotation pales in comparison to the changes that can take place over the long term. Sector analysis of the U.S. market between 1900 and 2000 shows us an interesting picture.

Just as a country's influence over global economics evolves, so do the sectors of an economy. As these two tables show, the economies of 1900 and 2000 had few similarities. Of particular note are the sectors that were small in 1900 and 2000. For instance, 84% of the sectors today (represented by market capitalization) were of immaterial size or were non-existent at the beginning of the last century. These sweeping changes also make extrapolating future market performance from past events difficult. (Check out Sector Rotation: The Essentials and The Stages Of Industry Growth.)

Technological advancements have a big impact on the stock market. Just as railroads consumed the investing public in the latter part of the nineteenth century, computers and the internet did the same at the end of the twentieth century. For all we know, the dominant sector at the end of the twenty-first century may not even exist today. Which technologies will have the most profound impact on the world's productivity in the future? In order to successfully invest in these technologies, you will need to predict these changes before they affect the market - a task that is much easier said than done.

Can the United States continue its dominance for another century? Change is inevitable, but one thing is certain: the stock markets of 2100 will look very different than those of today. The incredible advancements in telecommunications have left their mark on the world stock markets, and major centers like New York, London and Tokyo now dominate a once fragmented marketplace. It is easy to refer to the past, but when it comes to your own finances, make sure that your portfolio is structured for the future - in light of all the changes that the markets have undergone so far, basing it on what has occurred in the past may not make sense.

As far as the historical returns the stock market has brought to investors, it all depends on the time frame you examine, but let's take a very broad perspective.

Writing about historic stock market returns in the Concise Encyclopedia of Economics at www.econlib.org, Jeremy J. Siegel, Russell E. Palmer Professor of Finance at the University of Pennsylvania's Wharton School, states that "Over time, the total return on stocks has exceeded that of any other class of asset. ... One dollar invested in stocks in 1802 would have grown to $8.8 million in 2003, in bonds to $16,064, in Treasury Bills to $4,575, and in gold to $19.75."

Siegel also gives an average compound inflation-adjusted rate of return of 6.8% for the stock market from 1802 to 2002. He further notes, "A 6.8% annual rate of return means that if all dividends are reinvested, the purchasing power of stocks has doubled, on average, every ten years over the past two centuries."

An Unkind Century for Bond Investors
Equity investors triumphed over bond investors during the 20th century because the risk premium built into bonds during the 1900s was much too low to compensate investors for the turmoil that would hit the bond market over the next century. This period saw two secular bear and bull markets in U.S. fixed income, with inflation peaking at the end of the First and Second World Wars as a result of increased government spending during those periods.

The first bull market started after World War I and lasted until after World War II. According to Dimson, Marsh and Staunton, the U.S. government kept bond yields artificially low through the inflationary period of World War II and up to 1951. It wasn't until these restrictions were lifted that the bond market began to reflect the new inflationary environment. For example, from a low of 1.9% in 1951, long-term U.S. bond yields then climbed to a high of nearly 15% by 1981. This was the turning point for the century's second bull market.

The graph below shows real government bond returns for the 20th century. While all of the countries listed in the table below showed positive real returns on their equity markets during this period, the same could not be said about their bond markets.

The countries that did show negative real returns were those most affected by the world wars. For example, Germany saw two periods in which fixed income was all but wiped out. During the worst of the two periods, 1922-23, inflation reached an unfathomable 209,000,000,000%! According to "Triumph of the Optimists," 300 paper mills and 150 printing works with 2,000 presses worked day and night to accommodate the demand for bank notes during this period. In fact, the 20th century had more than one incidence of hyperinflation, but none was as severe as what Germany saw in the early 1920s. (For more insight, see the Inflation tutorial.)

The graph below contrasts real government bond returns for the first and second halves of the 20th century. Notice how the countries that saw their bond markets do very poorly in the first half of the 20th century saw a reversal in their fates in the second half:

While this illustration gives you a good feel for the government bond market, the U.S. corporate bond market, according to Dimson, Marsh and Staunton, fared better as well, and added an average 100 basis points above comparable government bonds over the 20th century. They calculated that roughly half of this difference was related to the default premium (the premium rewarded for taking on default risk). The other half is related to defaults, downgrades and early calls. (To learn more, see Corporate Bonds: An Introduction To Credit Risk.)

The Bond Market Would Never Be the Same
In the 1970s, the globalization of the world markets began again in earnest. Not since the Gilded Age had the world seen such globalization, and this change would really start to impact the bond markets in the 1980s. Until then, retail investors, mutual funds and foreign investors were not a big part of the bond market. According to Daniel Fuss' 2001 article "Fixed Income Management: Past, Present And Future," the bond market would see more development and innovation in the last two decades of the 20th century than it had in the previous two centuries. For example, new asset classes such as inflation-protected securities, asset-backed securities (ABS), mortgage-backed securities, high-yield securities and catastrophe bonds were created. Early investors in these new securities were compensated for taking on the challenge of understanding and pricing them. (To learn more, see Event-Linked Bonds: Competing Against a Catastrophe.)

Innovation in the 21st Century
Entering the 21st century, the bond market was coming off its greatest bull market. Long-term bond yields had compressed from a high of nearly 15% in 1981 to 7% by the end of the century, leading to higher bond prices. Innovation in the bond market also increased during the last three decades of the 20th century, and this trend will likely continue. Furthermore, securitization may be unstoppable, and anything and everything with future material cash flows is open to being turned into an ABS. Healthcare receivables, mutual fund fees and student loans, for example, are just a few of the areas being developed for the ABS marketplace.

Another likely development is that derivatives will become a bigger part of institutional fixed income with the use of such instruments as interest-rate futures, interest-rate swaps and credit default swaps. Based on issuance and liquidity, the United States and the Eurobond markets will maintain their dominance of the global bond market. As bond market liquidity improves, bond exchange-traded funds (ETFs) will continue gaining market share. ETFs have the ability to demystify fixed-income investing for the retail client through their tradability and transparency (for example, Barclays iShares website contains daily data on its bond ETFs). Finally, continued strong demand for fixed income by the likes of pension funds will only help accelerate these trends over the next few decades. (For more information, read Can You Count On Your Pension? and Bond ETFs: A Viable Alternative.)

Many retail investors shun the bond market because it can be difficult to understand and it doesn't offer the same level of potential upside as the stock market. Furthermore, investing in fixed income during the past century was not an overly lucrative proposition. As a result, today's fixed-income investor should demand a higher risk premium. If this occurs, it will have important implications for asset allocation decisions. Increased demand for fixed income will only help to further innovation.

Average Market Returns

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