This turbulence on global stock markets over the last 18 months has prompted many investors to examine why they should own equities. Although an understandable response given the destruction in equity values, it’s important to note how rare these extreme market events are. Over the long term, experts still believe equities will continue to provide higher returns than bonds or cash.
Historic case for equities
In the past, investing in equities has generated attractive long-term returns. US equities, for example, have produced average returns of 6.2% per annum in real terms over the last 159 years according to Credit Suisse, even when taking into account the recent sharp declines.
If we look back at the US stock market’s annual returns since 1825, 2008’s sharp 37% fall was very much a stand-out event. There have only been three years in the last 183 years that the US market has fallen by more than 30% – in 1931, 1937 and now in 2008. In Europe, real equity returns have trended around 7% per annum according to statistics that go back to 1926.So with markets currently at the low end of their historic range, it would be reasonable to assume that equities will revert to their long-term trend, higher than today’s position.
Real returns
One of the reasons for holding equities is the exposure to future rates of growth in profits and the consequent dividends that are paid out. In general, profits are cyclical and although current earnings have fallen below trend, long-term profits growth remains in an uptrend.
Over the long term the main driver of equity returns has been the dividend yield. From 1871 to 2008, the dividend yield in the US has averaged 4.5% per annum. This yield, plus real growth in dividends, has generated total real returns of 6.1% per annum. However, this long-term average has been dragged down by the past 25 years, during which the average market yield has fallen to 2.5% per annum. Excluding the period of the worldwide equity bull market, which began in 1982, the dividend yield of the US market has averaged 5% per annum.
Time in the market
Equities give a positive return in 72% of years (based on 183 years of US returns data). Moreover, positive years often come after negative years. So in years that equity markets give very poor returns,investors have a strong incentive to remain invested because the markets have a high probability of recovery. So it is important to remember with equities, it is ‘time in the markets’ that counts, not ‘timing the markets’.
There is, however, another more compelling reason for not giving up on equities at present, and it’s based on the fact that equities compete for your cash with other financial assets. This is especially pertinent now, where holdings in cash funds exceed holdings in equity funds for just the third time in 16 years.
That on its own doesn’t mean anything, but when we look at the rate of return on cash and fixed income it’s difficult to forecast anything other than meagre pickings, whereas at least in equities you are compensated for your capital risk with a decent yield: 6.3% in the UK; just less than 6% in Europe ex-UK; and 3.5% in the US. All of these exceed the yield on bonds, and while it is true that many sectors will be under pressure to reduce dividends, a lot of that expectation is embedded in the price. Equity markets could move sideways this year in a volatile range, and still outperform cash and bonds because of the income they pay out.
As you can see the experts still believe in the strength of equities. Pension funds should be invested intelligently and professionally to get the maximum growth. If your pension investments needs an update, contact QROPS.net for a free pension planning review.
