Money Matters

The Long Term Proof

Stock markets go up and down as events unfold, and the press loves nothing more than to report a big fall. Crashes are much more newsworthy than a steadily rising market and the media have had plenty of ammunition over the last year with a 30% fall in the UK stock market. Normally, advocates of equity investing can point to better returns over longer time periods. However, the table shows that argument cannot be made over the last two decades.

    
What it does show is that equity returns have been very poor recently 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 2009 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 usually beat bonds. So the longer you hold shares the more chance you have of beating the returns from other assets.

Time is a significant influence in reducing volatility. But another factor is perhaps even more important 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 they 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 2009 study it provides two tables that show the difference in a hypothetical portfolio of £100 invested in 1899.

The difference between £9,129 and £1,152,944 in nominal returns makes the case for reinvesting income very eloquently.

The importance of dividends over the longer term is made very powerfully by this graph from Societe Generale. It shows that while capital appreciation is important in the short term for periods of five years or more eighty percent of your return comes from dividends and growth in dividends.

If that doesn't convinve you how important dividends are then maybe this video clip by John Authors of The Financial Times might.

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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