Stocks, Bonds, Bills & Inflation

by David Ott

Every year, I look forward to getting my nice crimson, hard-bound copy of Ibbotson’s SBBI by the newly combined Ibbotson & Associates and Morningstar, Inc.

People routinely ask me if I actually read this book because it looks intimidating at first blush with the equations, data tables and obtuse text. The answer, though, is a resounding “Yes!”

It is true that SBBI is more of a reference book than anything else, but when you take it bite by bite over the years, much of the content becomes extremely familiar and you can focus on the newly incorporated material.

This year, the best of the new information is by Roger Ibbotson and Zhiwu Chen and describes the return premium that investors can reasonably expect by investing in illiquid securities, which they describe as an illiquidity premium.

In some respects this is an old argument, and one that David Swenson made about the relative advantages of investing in private equity, direct real estate or venture capital. Because the money is tied up, the investor should demand some additional return for this implied cost.

This argument is coming somewhat undone by the current financial crisis where liquidity (and price transparency) is in extremely high demand among all investors – including Swenson and other endowment managers.

Ibbotson’s research suggests that the illiquidity premium is also evident in publicly traded stocks. Looking at monthly data beginning in 1972 and ending in 2008, Ibbotson separated stocks from the NYSE, AMEX and NASDAQ into quartiles based on the turnover of the stock divided by the shares outstanding.

The most liquid shares returned 7.11 percent per annum over the entire timeframe and has a standard deviation of 27.32 (standard deviation is a measure of volatility). At the other end of the spectrum, the most illiquid stocks had annualized rates of return of 15.46 percent and a standard deviation of 19.81 percent.

At first, it seems illogical that illiquid stocks would be so much less volatile than liquid stocks since it is natural to equate illiquidity with risk. Further analysis would suggest that part of the reason for less volatility in illiquid stocks is that prices are measured less frequently.

Similarly, one would expect liquidity (or lack thereof) would be deeply intertwined with firm size – a well known phenomenon in stock returns over time. As it turns out, the illiquidity premium holds true on a size basis as well. The largest, most illiquid stocks returned 11.89 percent while the smallest, most illiquid stocks gained 17.35 percent. At the other end of the spectrum, the largest, most liquid stocks gained 4.09 percent while the largest, least liquid stocks gained 8.47 percent.

Of course, this is just one chapter in this year’s SBBI. Other equally illuminating chapters include in dept discussions of growth versus value stocks, large versus small stocks, international investing, investment returns starting in 1825, and so forth.

SBBI is an indispensible tool in understanding the capital markets past and present and offers a tremendous amount of information, analysis and methodology that are fundamental to understanding modern investing.

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Recommendation: Strong Buy

Ibbotson SBBI: 2009 Classic Yearbook

Morningstar, Inc. Chicago, IL 2009

ISBN: 978-0-9792402-4-9