Most investors have unrealistic expectations about their stock market investment programme. This column provides a much needed reality check.
Let's first clear the decks by acknowledging that shares do better than bonds or savings accounts over the long-term.
But "relative performance" does not pay the rent. If you do not believe in the importance of "absolute performance", see what happens when you tell your bank manager that you out-performed other investment classes last month but can not meet your current mortgage obligation because of a weak equity market.
It is not common knowledge but the annual average price gain in the UK during the last 300 years was around one per cent per year after correcting for inflation. Our chart shows this data divided into 25 year segments like 1700-24, 1725-49 and so on.
(Figures for the twentieth century provided by the Barclays Equity Gilt Study: 2008 Edition)
The trend remained in place despite repeated wars against the French, the loss of 13 colonies, a booming industrial revolution, two world wars and a great depression.
The sole notable exception to the rule was in the final quarter of the twentieth century when equities produced double-digit average annual gains. Unfortunately, stock market weakness since the start of the new century (the stock market is currently about 13 per cent below its starting point) suggests a return to the long-term trend
Two important points are made by this graph.
Dividends Really Do Count
Even if we include the final quarter of the twentieth century in the computations, the average annual share price gain over the very long-run is just one per cent per year. In contrast, the average annual return provided by dividends is somewhere around four per cent over the long-run.
In other words, four out of five pounds made from the stock market over the long-run is due to dividends, not capital appreciation.
Putting it another way, ignoring the effect of dividends over the long-term is akin to trying to swim across a raging river with both hands tied behind your back.
Some investors have special skill that enables them to spot small, non-dividend paying companies that will eventually rocket up in value. But objective statistics suggest these investors are few in number.
For the rest of us, dividends are quite important. Think about this before you purchase any further shares.
Increase Your Savings Rate For A Prosperous Retirement
Long-term capital appreciation from the stock market is much less than most investors realise. Gains or losses can be quite volatile in individual years of course. But over the longer run, the one per cent growth rate is remarkably consistent.
An investor might be extremely lucky (or unlucky) in any single 25 year period. But the very long-term message is remarkably clear. Even though equities out-perform other investment classes, it is a bit of a gamble to expect them to deliver a prosperous retirement. If you want to live in a fine style once you stop working, you must save more money right now.
Final Quarter Of The 20th Century
So far, we have ignored the tremendous gain in the fourth quarter of the last century.
The world definitely did change in 1975-99. Share rocketed up throughout the period. Price appreciation was so strong that the 1987 crash now looks like a tiny blip on a long-term graph. Was this the start of a new long-term stock market trend?
Commentators point to four factors that contributed to this superb performance.
…..We enjoyed a bounce-back from the horrid conditions of the 1970s.
…..Our leaders are doing a better job of managing the economic cycle. They are not perfect but getting better.
…..Our banking system is more efficient, less expensive and better able to finance economic expansion.
…..Growth in international trade helped to boost the profits of many of UK companies.
Will these factors continue to boost our stock market in the decades ahead? Probably not.
Let's start with bounce-back from 1970s. The current quarter-century is not being helped by bounce-back conditions. If anything, the reverse is true. Western stock market rose too much, too fast and we are now suffering from a monumental hangover.
Are our leaders doing a better job of managing the economy? Current economic conditions provide a pretty clear answer to this question.
Ex-Federal Reserve Chairman Alan Greenspan, now retired, is now trying to save his legacy by telling us a) no one could have foreseen the asset price bubble currently crippling the world economy, b) it is not the job of a central bank to prick bubbles and c) even if he wanted to, he could not have stopped a bubble from developing.
Many independent observers answer all three claims with one word – nonsense. In fact, the Federal Reserve is now studying these issues in order to prevent a re-run of the Greenspan years.
On this side of the Atlantic, we had Gordon Brown prancing around for the last 10 years taking full credit for a very successful British economy. Enough said.
Investors are learning that nothing can completely reverse an underlying economic cycle. Appropriate action can modify its shape a bit and delay a slowdown. But nothing can permanently eliminate one.
One reason is the law of unintended consequences.
When central bankers rescued financial markets in 1987 and 1998, the unintended consequence was that investors threw caution to the wind. After all, why worry about risk if the central bank will come to your rescue during times of economic weakness.
The law of unintended consequence has special relevance when it comes to commercial banks.
Back in the early 1980s, they chased higher profits by excessive lending to third world countries. They were stunned to learn they could not get their money back. Excessive lending in the early 1990s triggered another banking crisis, this one linked to a painful US real estate crisis.
Recall that cheap money helped to fuel the Tech Bubble which eventually ended with a huge drop in shares at the turn of the century.
More recently, poor bank lending and investing practices contributed to a fresh real estate bubble which is now in the process of unwinding. Knock-on effects from shabby sub-prime lending practices led to much wider economic problems.
It is still too early to draw cast iron conclusions but the final quarter of the 20th century is beginning to look like a short-term aberration. Recall that shares have lost 13 per cent since the start of the decade more than eight years ago.
The implication of this "return to trend" is worth repeating. For a prosperous retirement, you must save more money during your economically productive years. You can not rely on the stock market alone.