More about growth
The UK economy has been growing fairly steadily for a very long time. That means that the country has been getting steadily richer, and although there is a pretty wide gap between the richest and poorest people, even the poorest are better off than they would have been 100 or even twenty years ago.
This growth in our economy is important to investors for two reasons. Firstly, it means that our demand for all types of products and services is growing, and that the businesses that supply them are growing too. We could turn that around, and say that because our businesses are growing, the people who own them and work in them are getting richer. In fact it is a ‘chicken and egg’ situation: we spend more on products and services every year; the businesses that supply them make more money; and that benefits those who own and work in them, who can afford to spend even more… and so on.
Investments that grow: equities (shares)
Companies whose shares are traded on the London Stock Exchange represent a large piece of the UK economy. Let’s refer to this piece as UK plc. Although many of the fastest growing businesses are small and privately owned, UK plc has grown pretty much in line with the UK economy as a whole for as long as records have existed (well over 100 years). Of course, that doesn't mean that every company has grown. Things are changing all the time, and many companies that were successful say 50 years ago have long since changed beyond recognition or gone out of business. Some of our very largest companies today (Vodaphone for example) didn't exist even 20 years ago.
By investing in UK plc, we can benefit from UK economic growth. This has averaged around 6% a year for the past 100 years or so, of which about half is due to real growth and half to inflation. There have been periods when inflation has been extremely high, well into double figures, and when real growth has stopped and even gone into reverse. But if we look at the dividends that UK plc has paid over the years, we will see that they have more or less followed UK economic growth and grown at pretty much the same rate of around 6% a year. That means that after 12 years the dividends from UK plc have doubled, and after 19 years they have trebled. It is this growth over long periods that has made shares (equities) popular. It doesn't make them right for everyone, and there are some serious pitfalls, but it does mean they are important for those who need to invest for the long term.
What growth does to present value
We talked earlier about time being money, and how we can judge an investment by working out the present value (that is the value today) of cash we expect to receive some time in the future. If the present value of an investment is higher than its cost, then the investment makes sense. We still need to think about risk of course, but if the risks are the same then present value gives us a useful tool for comparing investments. Although the simple examples shown used fixed rates of return, we can do the same thing for income streams that we expect to grow. If we have shares in a company that has been paying higher dividends each year and we confidently expect it to carrying on increasing them at the same rate, then we can work out the present value and the overall rate of return.
There are obvious risks in doing that for just one company. Maybe it will start to lose market share to competitors or find it hard to maintain profit levels. Perhaps it has been paying out more than it can really afford. But if you have shares in a reasonable spread of companies (UK plc for example) then you can be fairly confident that dividends as a whole will grow pretty well in line with the economy. Dividends as a whole have only fallen in five years in the past 60, and even in those years shareholders will still have received something, just not quite as much as in the previous year. Dividends are absolute returns: once you've got the money it’s yours to save or spend as you wish. (In contrast, if the prices of your shares are higher than the prices you paid for them you have made a ‘paper’ return. Unless you sell the shares, it isn't a return you can spend, and in the meantime the prices can fall).
Growth and rates of return
The rate of return on a growing income stream is the yield at the start (that is how much you get as a percentage of what you've invested) plus the growth rate. If you invested in UK plc at a time when the yield was 4% (which is about average for the past 100 years) your rate of return in money terms will have been 4% plus the 6% growth rate, which makes 10% per year. The real rate of growth after allowing for inflation has been more like 2% a year, so you will still have been making around 6% in real terms and keeping pace with inflation too. A recent study shows that £1 invested in UK equities in 1900 with dividends reinvested would have grown to £13,253 by the end of 2003. Even after allowing for inflation, the spending power of that £1 investment would have grown 224 times. No other financial investment comes close over that length of time.
Growth and real assets
This brings us to the second reason why economic growth is important to us as investors: poverty is relative. Even if our spending power is keeping up with inflation, we will still feel poorer if our spending power isn't keeping up with other people. At various times there have been attempts to link state pensions to average earnings because average earnings reflect economic growth and the increased spending power that working people have as a consequence. That aim has long since been abandoned. As we've already seen in the page on pensions, the state will be struggling to meet the cost of an aging population with even basic pension and health care provision. If you are investing long-term you must think seriously about trying to hitch your investment performance to the economy. Even if the economy slows down, you haven’t really lost anything. And if it carries on growing then at least part of your wealth should be growing with it.
The ‘natural’ rate of return
The average rate of return for the main financial classes – equities, bonds, and cash – for the past 100 years has been highest for equities at 9.8% per year in money terms. Inflation averaged 4% a year over the same period. You would have made just under 10% a year by investing in UK plc (or a representative selection of UK listed companies), and reinvesting the dividends by buying more shares of the same companies. You wouldn't have to be buying and selling all the time: all you needed to do was gradually phase out declining industries and bring in companies in newer ones so your portfolio stays truly representative. We would call this ‘passive investing’. It’s what you get if you buy so-called ‘index tracker’ funds (except that trackers charge management fees which will bring your returns down – see assets - shares).
You might get better returns by being selective (and more risky), buying shares that have certain characteristics. You might do better by moving in and out of the market at different times in the economic cycle. But you might easily do worse. There are plenty of investment styles (it might be more accurate to call them speculation styles) and you might have some fun and maybe make some extra money. Unfortunately it will be at the expense of other investors (or at your own expense at another time) but that’s a fact of economic life.
You can see that the natural rate of return on equities has been 9.8% a year historically. With the yield on the FTSE All share index currently at 3%, real economic growth at between 2 ½ and 3%, and inflation at 2 to 2 1/2 % we are likely to see a rate of return of around 7 to 9% a year in money terms. However, the market yield of 3% is slightly lower than the long-term average, suggesting that prices might be a little above trend.
Thinking about assets
We hope that pages in this and the preceding sections have given you some food for thought about investing in general. In the next section we will be looking at each asset class in a bit more depth.
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|