The Holy Grail for investors: the two things everyone should know.
Almost all investments are second hand
When you buy any investment – shares, property, antiques, works of art – you are almost certainly buying it from somebody else. When you come to sell it again, you will almost always be selling it to somebody else. So you should ask yourself ‘what does that seller or buyer know about this investment that I don’t?’ Maybe the answer is that they don’t know anything more than you. They might not know as much as you. On the other hand, they might understand the second law of investment, which is…
No investment will grow for very long at more than about 3% a year in real terms
Ultimately, it is economic growth that drives investment growth. The sales and profits of businesses as a whole, and the salaries and wages (and pensions) of almost everyone in the country depend on the economy. In fact, they are the economy. The value of a share depends on how much money the company makes. The value of a property depends on how much somebody is willing and able to pay to buy or rent it. Although one company’s profits, or the salaries of a particular group of people, might grow faster than 3% a year in real terms for a while – perhaps even for quite a long time – that growth can’t last forever. If it did, that company or those few people would eventually own everything in the country simply because their wealth would be growing faster than the economy.
Economic growth in money terms also depends on inflation. Both real growth and inflation can vary quite a lot from year to year – inflation has been well into double figures for fairly short periods – but the average for real growth of the UK economy between 1946 and 2000 was 2.4% a year. Over the same period, both house prices and share prices grew at a slightly lower rate than the economy, although both have grown faster over the last few years. Inflation averaged about 7% over the same period, but current expectations for inflation are probably around 2% a year. Looking ahead, economic growth in money terms of around 5% would be a fairly safe bet.
This growth rate effectively limits the long-term rates of return.
The rate of return on an investment is the yield plus the growth rate. The average yield on all shares has been around 4% since 1946, and is currently 3.1%. Rental yields on properties tend to be around 7% but they are less liquid and typically involve higher management costs. Long-term real rates of return on shares will therefore be around 6%, and on rental properties maybe around 10% before management costs, and about 2% higher in money terms. Interestingly, the Institute of Actuaries specifies that 7% is the maximum compound rate of return in nominal (money) terms that should be used in future pension projections.
If your pension fund or life assurance company or anyone else is promising you a rate of return in double figures, be very suspicious! This is exactly the reason why we have horror stories about under-funded pensions and the miss-selling of endowment mortgages and other financial products. In the case of pensions there are other issues too, most notably the Government moving the goal posts through taxation, but over-optimistic expectations of investment returns (combined with unrealistic estimates of mortality) are a major part of the crisis.
I emphasised long-term returns and class of investment for good reason. Pension and endowment funds got into trouble because they convinced themselves (or at least their customers) that the high rate of return they were getting on equities (shares) during the 1980s and 90s would continue. It didn't. But they did have a good run for quite a time, even though common-sense should have warned them that it couldn't last. This illustrates the point about timing. What I call the normal rate of return is the long-term average. There will be periods when returns are much better – and much worse – than this. But high rates of return today will be followed by low rates of return tomorrow, as sure as night follows day.
There is a saying in poker that if you don’t spot the patsy (the loser) in the first 10 minutes then it’s you. That goes for investing too. You can only make more (than the normal rate) at the expense of somebody else. It means you are buying when most other people are selling and selling when they are buying. If you are really smart then for a long time you might make returns that are above normal - but it will inevitably be at somebody else’s expense.
That’s true over time and it’s true within the asset class. If you buy every share and keep them indefinitely you will make something between 6% and 10% a year on average. Get the timing right and you can make more, but only because other people make less. Big institutions hold a lot of investments and keep them a long time. They will make average returns. Small investors can pick and choose what and when to buy and sell. If we are smart we buy investments that do better than average and we buy and sell at the right times.
If we make more than the normal over a long period then we can pat ourselves on the back and shed a tear for those who have suffered as a result of us being smart. Someone has sold when we thought it was time to buy (when prices are low) and bought when we decided we should get out (when prices are high). That applies to the market as a whole and to individual investments.
Now you should be able to see what I mean about these two nuggets of investment wisdom. We rely on these glorified car-boot sales we call ‘the markets’ for making returns that are higher than normal. If we ‘beat the market’ we are actually beating the next guy: the guy who buys off us or sells to us. We are making money at his (or her) expense. So what do we know that they don’t? If we try to beat the market we might easily end up being the loser. The alternative is to settle for steady long-term average returns - and that’s the safest way to bet. If you are an institution, that’s the only way to bet.
[Data sources for the above figures: Barclays Capital Equity Gilt Study; www.eh.net (economic history)].