# AEX closes at 903

Believe it or not, but last Friday the 31^{th} of August, the AEX closed at 903. Can that really be true? The popular press after all reported 329, a number that probably sounds much more familiar. What is going on?

The difference is simple, yet profound. 329 is the level of the AEX *price* index, which only reflects the (change in) the level of stock prices, but does not include any return from dividends. 903 is the level of the AEX *total return* index, that does include reinvested dividends.

This would not be a big issue if dividends were only a marginal part of an investor’s overall return, but this is not the case. The companies that were included in the AEX index paid out dividends of 3,7% per year on average since its inception on January 1^{st} 1983 (by the way, the current dividend yield of 3,6% is very close to that average).

The compounding effect of these dividends is quite remarkable. The AEX started on January 1, 1983 at 45.38 (or 100 in Dutch Guilders). Last Friday’s closing value of the AEX *price* *index *of 329 indicates a total return of 625%, a cumulative average return of 6.9% per year over the 29.7-year horizon. The AEX *total return *index closing value of 903, shows that investors who bought the shares of the underlying companies and reinvested the dividends, would have seen a 1890% increase in value, or 10,6% annual return over the same period (assuming for simplicity’s sake that he or she did not have to pay any costs of investing, which in reality is not the case).

In other words, a real investor, investing in real companies would have seen a 19 fold increase in wealth and earned almost **three times** as much as implied by the index reported by the media.

**What are the other drivers of return?**

Dividend yield represents one of the two major drivers of an investor’s real long term return. The other is earnings growth. Companies after all do not pay out their entire earnings in dividends. The ‘dividend payout ratio’, as the share of dividends compared to total net earnings is called, stands at about 40% on average across the globe. The other 60% of the profit pie is used by companies to reinvest in their business or to acquire new ones. These investments generate growth in earnings, which in turn leads to growth in dividends.

Unfortunately, there is a third, more fickle factor, which has a major impact on the *shorter-term*results of a stock investor. This is the valuation of a company’s stock: the price that ‘the market’ puts on a company’s, current and expected profits, often measured by the Price/Earnings or P/E ratio (the current market price of a stock, divided by its current or expected earnings per share).[ref]The P/E ratio is basically the inverse of profitability. The current average P/E ratio of 11 for the AEX for instance indicates a rate of profitability of 1/11 or 9,1% earnings/market price. As earnings can also change significantly year on year, long-term investors often use a 10 year trailing P/E ratio as a better proxy for valuation: the current market price divided by the average profits over the past 10 years (adjusted for inflation).[/ref]

As most of us have had to experience, unexpected events can cause dramatic fluctuations in the valuation and therefore the prices of single stocks and the market as a whole. In the long run however, this change in valuation is not as significant as most people think or fear.

This is illustrated by a breakdown[ref]Data from CBS, NYSE Euronext Amsterdam and Wellershoff & Partners Ltd.[/ref] of the 10,6% total return of the AEX since 1983. First we’ll subtract inflation, as investors should be interested in real, purchasing power adjusted, returns. Average inflation over this period was 2.1% per year, so real returns were 8.5%. Breaking this annual return number down into the three factors we discussed leads to the following:

1) Dividends 3,7%

2) Real growth in earnings/dividends 2,9%

3) Change in valuation level compared to 1983 1,9%

**= real returns since January 1983 8,5%**

The graph below shows that other countries have ‘suffered’ similarly sized effects of changes in valuation over the last 40 years. It shows that real returns are mostly driven by dividends and profits, and less so by the changes in prices and valuation, which nevertheless seems to be the main object of the media’s and most investors’ attention.

**Composition of annualized real market returns 1970-2011[ref]Source: Société Générale, based on 10-year rolling window averages of MSCI index returns. Adjusted for inflation and in local currencies. This graph includes the high inflation 70’s which were characterized by low real returns.[/ref]**

**Conclusion**

All this does not mean we should ignore market fluctuations altogether. In the short term a collapse of market valuations can be very painful, whether you include dividends or not. You should therefore only invest in the stock market if you have a long-term horizon of at least 7 years. However with investing there are no guarantees, regardless of the period. This is illustrated by the AEX graph below. As you can see, even including dividends, unlucky investors who bought shares at the very peak on September 4, 2000 (exactly 12 years ago today!) would have lost about 30% of their capital as of today. Significantly better than the 53% drop that is suggested by the AEX price index, which fell from its 701 peak to the 329 level of today, but very painful nonetheless.

As you know, we therefore recommend that you diversify your holdings, preferably across the globe. That only pays off if you have the discipline to ‘stay the course’ and refrain from switching every time the market turns. Given the increased volatility and constant media attention to index swings, that’s harder to do than ever, but it remains essential to your long term success as an investor. A globally diversified portfolio, rigorously rebalanced every year, would have actually made a return of 3,7% after costs since that peak in September 2000. Still not great, but remember this would have been the return if you were unlucky enough to buy into the market, when many valuations turned out to be at all time highs.

Current valuations[ref]With 10-year trailing P/E ratio of around 12 in Europe and 21 in the US.[/ref] are much closer to their long-term average than they were back then. This doesn’t mean there are no risks, but it gives long-term investors a better chance to profit from the real fruits of capitalism: dividends and earnings growth. In that regard we hope that dismissing the media’s focus on the AEX price index, and a reminder that the relevant number is actually almost 3 times as high, makes you a bit less pessimistic about the past and a bit more optimistic about the future.

Believe it or not, but last Friday the 31^{th} of August, the AEX closed at 903. Can that really be true? The popular press after all reported 329, a number that probably sounds much more familiar. What is going on?

The difference is simple, yet profound. 329 is the level of the AEX *price* index, which only reflects the (change in) the level of stock prices, but does not include any return from dividends. 903 is the level of the AEX *total return* index, that does include reinvested dividends.

This would not be a big issue if dividends were only a marginal part of an investor’s overall return, but this is not the case. The companies that were included in the AEX index paid out dividends of 3,7% per year on average since its inception on January 1^{st} 1983 (by the way, the current dividend yield of 3,6% is very close to that average).

The compounding effect of these dividends is quite remarkable. The AEX started on January 1, 1983 at 45.38 (or 100 in Dutch Guilders). Last Friday’s closing value of the AEX *price* *index *of 329 indicates a total return of 625%, a cumulative average return of 6.9% per year over the 29.7-year horizon. The AEX *total return *index closing value of 903, shows that investors who bought the shares of the underlying companies and reinvested the dividends, would have seen a 1890% increase in value, or 10,6% annual return over the same period (assuming for simplicity’s sake that he or she did not have to pay any costs of investing, which in reality is not the case).

In other words, a real investor, investing in real companies would have seen a 19 fold increase in wealth and earned almost **three times** as much as implied by the index reported by the media.

**What are the other drivers of return?**

Dividend yield represents one of the two major drivers of an investor’s real long term return. The other is earnings growth. Companies after all do not pay out their entire earnings in dividends. The ‘dividend payout ratio’, as the share of dividends compared to total net earnings is called, stands at about 40% on average across the globe. The other 60% of the profit pie is used by companies to reinvest in their business or to acquire new ones. These investments generate growth in earnings, which in turn leads to growth in dividends.

Unfortunately, there is a third, more fickle factor, which has a major impact on the *shorter-term*results of a stock investor. This is the valuation of a company’s stock: the price that ‘the market’ puts on a company’s, current and expected profits, often measured by the Price/Earnings or P/E ratio (the current market price of a stock, divided by its current or expected earnings per share).[ref]The P/E ratio is basically the inverse of profitability. The current average P/E ratio of 11 for the AEX for instance indicates a rate of profitability of 1/11 or 9,1% earnings/market price. As earnings can also change significantly year on year, long-term investors often use a 10 year trailing P/E ratio as a better proxy for valuation: the current market price divided by the average profits over the past 10 years (adjusted for inflation).[/ref]

As most of us have had to experience, unexpected events can cause dramatic fluctuations in the valuation and therefore the prices of single stocks and the market as a whole. In the long run however, this change in valuation is not as significant as most people think or fear.

This is illustrated by a breakdown[ref]Data from CBS, NYSE Euronext Amsterdam and Wellershoff & Partners Ltd.[/ref] of the 10,6% total return of the AEX since 1983. First we’ll subtract inflation, as investors should be interested in real, purchasing power adjusted, returns. Average inflation over this period was 2.1% per year, so real returns were 8.5%. Breaking this annual return number down into the three factors we discussed leads to the following:

1) Dividends 3,7%

2) Real growth in earnings/dividends 2,9%

3) Change in valuation level compared to 1983 1,9%

**= real returns since January 1983 8,5%**

The graph below shows that other countries have ‘suffered’ similarly sized effects of changes in valuation over the last 40 years. It shows that real returns are mostly driven by dividends and profits, and less so by the changes in prices and valuation, which nevertheless seems to be the main object of the media’s and most investors’ attention.

**Composition of annualized real market returns 1970-2011[ref]Source: Société Générale, based on 10-year rolling window averages of MSCI index returns. Adjusted for inflation and in local currencies. This graph includes the high inflation 70’s which were characterized by low real returns.[/ref]**

**Conclusion**

All this does not mean we should ignore market fluctuations altogether. In the short term a collapse of market valuations can be very painful, whether you include dividends or not. You should therefore only invest in the stock market if you have a long-term horizon of at least 7 years. However with investing there are no guarantees, regardless of the period. This is illustrated by the AEX graph below. As you can see, even including dividends, unlucky investors who bought shares at the very peak on September 4, 2000 (exactly 12 years ago today!) would have lost about 30% of their capital as of today. Significantly better than the 53% drop that is suggested by the AEX price index, which fell from its 701 peak to the 329 level of today, but very painful nonetheless.

As you know, we therefore recommend that you diversify your holdings, preferably across the globe. That only pays off if you have the discipline to ‘stay the course’ and refrain from switching every time the market turns. Given the increased volatility and constant media attention to index swings, that’s harder to do than ever, but it remains essential to your long term success as an investor. A globally diversified portfolio, rigorously rebalanced every year, would have actually made a return of 3,7% after costs since that peak in September 2000. Still not great, but remember this would have been the return if you were unlucky enough to buy into the market, when many valuations turned out to be at all time highs.

Current valuations[ref]With 10-year trailing P/E ratio of around 12 in Europe and 21 in the US.[/ref] are much closer to their long-term average than they were back then. This doesn’t mean there are no risks, but it gives long-term investors a better chance to profit from the real fruits of capitalism: dividends and earnings growth. In that regard we hope that dismissing the media’s focus on the AEX price index, and a reminder that the relevant number is actually almost 3 times as high, makes you a bit less pessimistic about the past and a bit more optimistic about the future.

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