Why not invest in US stocks?

mozza78

masonic wrote: »

I'll caveat this by saying I haven't done this experiment, but if you take the universe or available investment funds and plot volatility against 5 or 10 year returns, I don't think the correlation would be very strong. There are other metrics, such as the PE10 jamesd mentioned, that are far better predictors of future returns, but even those are somewhat flawed. Long term historical returns, which you mention, are a much better indicator than volatility.

Sorry I'm not saying that there aren't better indicators of future returns than volatility (it's notoriously lousy) I was originally trying to answer the OP question of why people would choose not to invest in US stocks rather than UK stocks given the higher returns historically in the US. My answer is that US stocks are inherently 'riskier' (certainly as defined by the std deviation) and as such they command a higher expected return from investors. There's an economic concept called the indifference curve which you could plot expected return versus volatility and its generally positively correlated for most people. Why do people not invest everything in emerging markets given their much higher returns on average? Because people are aware they're a lot more volatile and don't have that kind of risk tolerance/appetite.

masonic

mozza78 wrote: »

Sorry I'm not saying that there aren't better indicators of future returns than volatility (it's notoriously lousy) I was originally trying to answer the OP question of why people would choose not to invest in US stocks rather than UK stocks given the higher returns historically in the US.

Ok...

My answer is that US stocks are inherently 'riskier' (certainly as defined by the std deviation) and as such they command a higher expected return from investors.

This is the bit I disagree with. For one thing, I don't believe the difference in volatility between the US market and the UK market is statistically significant, although I'm happy to be corrected. There are other reasons why investing in the US could be considered more or less risky than investing in the UK.

That aside, it does not follow that the US market commands a higher expected return than the UK. That would imply the volatility and returns are highly correlated in general and I do not believe that is the case.

There's an economic concept called the indifference curve which you could plot expected return versus volatility and its generally positively correlated for most people. Why do people not invest everything in emerging markets given their much higher returns on average? Because people are aware they're a lot more volatile and don't have that kind of risk tolerance/appetite.

If high volatility commanded higher expected returns, then the risk would necessarily be lower. One could invest knowing that the ups and downs would eventually lead to high returns. Those ups and downs would be inherently less worrying because the long term returns would be to some extent guaranteed. Unfortunately, that is not the case. High volatility investments can have poor outcomes even over the long term.

One cannot rely on highly volatile markets such as EM to deliver higher returns than developed markets in the future. They do not have the same track record as developed markets and track record is a more reliable indicator than volatility in my view. Investors might also be put off by the volatility itself, but volatility is not the only aspect of risk. I think it is equally likely that investors would be put off by the possibility that these markets are not going to deliver a return that is commensurate with their risk (i.e that they won't command a higher expected return).

mozza78

I understand that the UK could be considered riskier than US in some measures hence the inverted commas as the definition being measured merely as a mathematical one of standard deviation. I do agree the deviation between the two isn't that significant.. In the last 30 years the economies are so closely aligned that if we look since the FTSE opened then its 17% US v 15% UK std dev but then neither are the returns all that different either really.. 9.5% v 7% gross ex dividend.

masonic

mozza78 wrote: »

I understand that the UK could be considered riskier than US in some measures hence the inverted commas as the definition being measured merely as a mathematical one of standard deviation. I do agree the deviation between the two isn't that significant.. In the last 30 years the economies are so closely aligned that if we look since the FTSE opened then its 17% US v 15% UK std dev but then neither are the returns all that different either really.. 9.5% v 7% gross ex dividend.

Agreed. Just for fun, it can be interesting to look at others' views on expected returns vs. volatility. One organisation that was often mentioned by a former poster here was Research Affiliates, who produce a scatter plot here. It is interesting to note that they currently have the US (large cap) market as lower volatility than any other market listed, but of course that's measured in USD and currency risk is well known to play a part in volatility. It is also noteworthy that their outlook is very dim for the USA and surprisingly bright for the UK (this was updated at the end of July, so is post-Brexit). What's also interesting to note is that the expected returns for emerging markets shown in green on the plot puts them some way away from any 'efficient frontier' and suggests in the main that RA's expectation is that the higher volatility will not lead to higher returns. Russia is perhaps an exception, but I'd take the predictions with a pinch of salt.

bowlhead99

mozza78 wrote: »

II do agree the deviation between the two isn't that significant.. In the last 30 years the economies are so closely aligned that if we look since the FTSE opened then its 17% US v 15% UK std dev but then neither are the returns all that different either really.. 9.5% v 7% gross ex dividend.

Well, just over that particular time period, you're saying the SD is only a little wider (seventeen is only two fifteenths larger than fifteen) while the return is significantly improved (9.5 is 35% greater than 7). So I'm not sure it's right to say the two didn't deviate much and the returns weren't that different.

Of course, the return probably shouldn't be looked at with a zero benchmark (I.e. 9.5 is 9.5 greater than zero while 7 is 7 greater than zero, so the US return is higher than UK by 35%). Instead, consider the baseline as being a risk free rate which is non-zero. If a risk free return was 3%, then the US performance premium was 6.5% and the UK one was only 4%, so the outperformance by the US was much more than 35%, more like 63%.

In reality the practical 'risk free' return is probably different for two retail market participants on the opposite sides of the Atlantic. And I didn't see your workings so I don't know which UK and US indexes you used - some are more balanced and suitable as investments than others. The above is just an example of how you can read all sorts of things into historic data depending on which days points you pick and what arguments you want to make.

mozza78

masonic wrote: »

Agreed. Just for fun, it can be interesting to look at others' views on expected returns vs. volatility. One organisation that was often mentioned by a former poster here was Research Affiliates, who produce a scatter plot here. It is interesting to note that they currently have the US (large cap) market as lower volatility than any other market listed, but of course that's measured in USD and currency risk is well known to play a part in volatility. It is also noteworthy that their outlook is very dim for the USA and surprisingly bright for the UK (this was updated at the end of July, so is post-Brexit). What's also interesting to note is that the expected returns for emerging markets shown in green on the plot puts them some way away from any 'efficient frontier' and suggests in the main that RA's expectation is that the higher volatility will not lead to higher returns. Russia is perhaps an exception, but I'd take the predictions with a pinch of salt.

Yeah amazing the number of quite serious financial people who don't really understand the nature of currency risk. A good number of friends lost a lot of money on quanto mortgages not realising what they had got themselves into some years ago. My own spreadsheets are defaulted in GBP terms so the returns on my foreign investments post Brexit look fantastically green until I toggle them back to their base currency and the page takes on a more reddish hue!

mozza78

bowlhead99 wrote: »

Well, just over that particular time period, you're saying the SD is only a little wider (seventeen is only two fifteenths larger than fifteen) while the return is significantly improved (9.5 is 35% greater than 7). So I'm not sure it's right to say the two didn't deviate much and the returns weren't that different.

Of course, the return probably shouldn't be looked at with a zero benchmark (I.e. 9.5 is 9.5 greater than zero while 7 is 7 greater than zero, so the US return is higher than UK by 35%). Instead, consider the baseline as being a risk free rate which is non-zero. If a risk free return was 3%, then the US performance premium was 6.5% and the UK one was only 4%, so the outperformance by the US was much more than 35%, more like 63%.

In reality the practical 'risk free' return is probably different for two retail market participants on the opposite sides of the Atlantic. And I didn't see your workings so I don't know which UK and US indexes you used - some are more balanced and suitable as investments than others. The above is just an example of how you can read all sorts of things into historic data depending on which days points you pick and what arguments you want to make.

All valid points.. was just a back of a napkin calculation based on FTSE100 and the S&P500.. didnt take any CPI or RPI figures into account either which actually only furthers the point that US returns are stronger as the UK has had higher inflation in that time I'm pretty sure. And yes picking and choosing your data to back your argument is something Disraeli pointed out is all too commonplace.