How have foreign stocks historically fared? (MoneyWatch) Elroy Dimson, Paul Marsh and Mike Staunton are well known for their research on stock market returns. Their 2002 book, "Triumph of the Optimists," provided evidence on stock market returns and the equity risk premium from 19 countries -- two North American markets (the U.S. and Canada), eight markets from Euro currency area (Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands and Spain), five other European markets (Denmark, Norway, Sweden, Switzerland and the U.K.), three Asia-Pacific markets (Japan, Australia and New Zealand), and one African market (South Africa). In October, they updated their data through 2010. These 19 countries accounted for an estimated 89 percent of the world stock market in 1900. The remaining 11 percent came from markets that existed in 1900, but no data is available, as markets failed to survive (such as Russia in 1917 and China in 1949) and investors were wiped out. To quantify the maximum possible impact of omitted markets on the magnitude of the historical equity risk premium, the authors made the extreme assumption that all omitted markets became valueless, and that occurred for every omitted country in a single year. They calculated what risk premium investors would have earned if in 1900 they had purchased a holding in the entire world market, including countries omitted from the DMS database, and held this portfolio for 111 years. Investment returns can be extremely volatile. Losses can be huge. From peak to trough, U.S. stocks fell by 79 percent in real terms in the 1929-1931 Wall Street crash. The worst period for U.K. equities was the 1973-74 bear market, with stocks falling 71 percent in real terms, and by 57 percent in a single year (1974). 2008 was the worst year on record for eight countries, for the world index, the world ex-USA, and Europe. For their 19-country world index, over the entire 111 years, geometric (compound) mean real returns were an annualized 5.5 percent, the equity risk premium relative to Treasury bills was an annualized 4.5 percent, and the equity premium relative to long-term government bonds was an annualized 3.8 percent. In the U.S. stocks returned 9.4 percent per year, bonds 4.8 percent, T-bills 3.9 percent, and inflation rose 3 percent. The real stock return was positive in every location, typically 3 percent to 6 percent per year. Stocks were the best performing asset class within every market and bonds beat bills everywhere -- exactly as we would expect since stocks are riskier than bonds and bonds are riskier than shorter-term bills. While in most countries bonds gave a positive real return, six countries experienced negative real returns. With the exception of Finland, the others were also among the worst stock performers. Their poor performance mostly dates to the first half of the 20th century -- these countries suffered most from the ravages of war and civil strife, and from periods of high inflation or hyperinflation, typically associated with wars and their aftermath. U.S. stocks did well, but the U.S. wasn't the top performer. Our returns were not especially high relative to the world averages. The real return on U.S. stocks of 6.3 percent is 1.3 percent higher than the average of the other 18 countries. U.S. stocks experienced a standard deviation of 20.3 percent, sixth-lowest behind Canada (17.2 percent), Australia (18.2 percent), New Zealand (19.7 percent), Switzerland (19.8 percent), and the U.K. (20 percent). The world index has a standard deviation of just 17.7 percent, showing the risk reduction obtained from international diversification. The most volatile markets were Germany (32.2 percent), Finland (30.3 percent), Japan (29.8 percent), and Italy (29 percent), which were the countries most seriously affected by the depredations of war and inflation. In Finland's case, its volatility reflected its heavy concentration in a single stock (Nokia) during more recent periods. The dividend yield has been the dominant factor historically. Across all 19 countries, the mean yield was 4.5 percent. It was as large as 5.8 percent (South Africa) and as low as 3.5 percent (Switzerland). In the U.S., it was 4.2 percent. For the world index, the annualized dividend yield was 4.1 percent, which is 3.1 percent higher than the real risk-free return from Treasury bills. Surprisingly, they found that the equally weighted average rate of real dividend growth across the 19 countries was slightly negative (-0.1 percent). For the U.S., dividend growth was 1.4 percent (the highest for any country). An expansion in the price-to-dividend ratio enhanced returns slightly (0.5 percent). For the U.S., the expansion contributed 0.6 percent to returns. The impact on the equity risk premium from survivorship bias is negligible, about 0.1 percent. The authors also took a stab at estimating the forward-looking equity risk premium. They began with the current yield on the world index of about 2.5 percent, well below the long-run historical average. Assuming future real dividend growth of 2 percent, the prospective geometric premium on the world index is just 3 percent to 3.5 percent, depending on the assumption made about the likely future real risk-free rate. The corresponding arithmetic mean risk premium would be around 4.5 percent to 5 percent. Both are below the historical average. The message for investors is to be careful to avoid building return assumptions in your investment plan that rely on historical (backward-looking) metrics. If the authors are correct, and most financial economists today agree with their conclusion, doing so is likely to lead to not meeting your financial goals. Image courtesy of Flickr user Horia Varlan