Money Matters

The Long Term Proof

Stock markets go up and down as events unfold, and the news loves nothing more than to report a big fall. Crashes are much more newsworthy than a steadily rising market. But the fact is, as research from Barclays Bank shows, that the stock market generally gives better returns than other assets over periods of longer than ten years. It is not always the case, but it is true more often than not. In the ten years to the end of 2007 equities, that is shares in the UK stock market, delivered an annual average return of 3.1%. Not fantastic and less than the 4.2% returned by corporate bonds.  But it is more than the 2.5% you got by holding cash. However, over a longer period, the last 20 years, equities have delivered an average annual return of 6.7% compared to 5.1% for bonds and 3.5% for cash. In more detail the long term real returns, i.e. after allowing for inflation, up to the end of 2006 are shown in the table below:

	%	2007	10 Years	20 Years	50 Years	107 Years
	Equities	1.0	3.1	6.7	7.2	5.3
	Gilts	-1.2	3.3	5.1	2.4	1.1
	Cash	1.8	2.5	3.5	2.0	1.0

    
This table shows that 2007 was not good for shares, with real cash returns outperforming equity returns for the first time since 2001.  The last ten years have not been bright either, with gilts outperforming equities by a small amount. But that is the exception as the other data shows. What is does show is that equity returns are unevenly distributed over time. But over a long period of time equities always do better than bonds. This extra return is known as the equity risk premium and is essentially the compensation an investor gets for putting up with volatile returns over short periods. Another way to express this is to look at the variability in returns over different holding periods. The graph below from the Barclays Equity Gilt study from 2008 demonstrates that equity returns can be very volatile in any one year period.  But as the holding period increases the volatility diminishes and become more skewed to a positive outcome. And after ten years they always beat bonds. So the longer you hold shares the more chance you have of making more money than from other assets.

 

Time is a significant influence in reducing volatility. But another factor is perhaps even more significant and that is the value added by reinvesting the income stream. Most shares pay out a dividend from the profits earned and this cash is the only tangible benefit a shareholder gets from investing in equities until he or she sells the holding.  But by reinvesting those dividends back into shares the investor gets the benefit of compound interest on a bigger investment.   And compound returns are where you make your money over time. Here is how the magic of compound returns works. Imagine you have £2,000 to invest on January 1st. You put £1,000 on deposit with bank at 2.9% and you put £1,000 into the stock market in an average year. On December 31st those funds have grown to £1,029 and £1,066 respectively, before fees. Now suppose that you leave those funds where are for another year so your starting figures are £1,029 and £1,066. After another year of similar returns those two pots are worth £1,058 and £1,136. The difference between the two is widening more and more every year. Repeat that process for ten years and the figures start to look quite impressive.  Remember though that these figures are before fees, and the compound effect of fees is just as powerful, but works against you as we explain later.

The Barclays Equity Gilt Study has provided an even more powerful demonstration of the benefits of receiving an income and then reinvesting it. In its 2008 study it provides two tables that show the difference in a hypothetical portfolio of £100 invested in 1899.

The difference between £13,580 and £1,641,485 makes the case for reinvesting income very eloquently.

Cash is certainly the best place to hold savings that you might need to access within ten years. Even better is to pay off any debt that you can, as long as you don’t incur any penalties. Paying down debt is risk free, you don’t have to pay any tax on the interest income and almost certainly the interest the bank charges on borrowings will be more than it pays you on savings. After all, that is how banks make their money.

But if you are looking for somewhere to invest for several decades, whether it is for your retirement, elderly care home fees or on behalf of a child’s education in twenty years’ time all the data shows that the stock market is the best place to do it. But how?

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