The scary truth about shares

by Cliff D'Arcy on 09 July 2011  |  12 comments
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Buying shares doesn't guarantee future wealth, even after decades of patient investing.

Conventional wisdom says that the highest long-term gains come from investing in shares.

Indeed, according to the Barclays Equity-Gilt Study 2011, returns from shares have thrashed those produced by cash and gilts (UK government bonds), as my first table shows:

Real returns, 1899-2010

This table shows the average annual return, in 'real' terms (after stripping out inflation) for shares, gilts and cash over 111 years. As you can see, cash deposits have risen a mere 1% a year ahead of the cost of living, with gilts beating inflation by 1.2% a year.

However, equities (shares) have beaten inflation by a healthy 5.1% a year, making them a much better bet over the long term. As a result, we should keep most of our wealth in shares, agreed? Not so fast!

Here's what's happened since the turn of this century:

Real returns, 2000-2010

As you can see, the best-performing asset class from 2000 to 2010 was ultra-safe government gilts, which beat inflation by 2.4% a year. Next was cash, producing a real return of 1.1%, with shares generating a yearly return just 0.6% above inflation.

This brings me to my first of my scary truths about equity investing:

1. Shares can underperform for years

As I write, the blue-chip FTSE 100 index stands at 5,976. The 'Footsie' first exceeded this level on 19 March 1998.

Thus, the UK's main stock-market index is lower today than it was over 13 years ago. In other words, a lump sum invested across the entire FTSE 100 in March 1998 would be worth no more today than it was back then.

Of course, this comparison ignores one important factor: the dividend income paid to shareholders. Many listed companies return cash to their shareholders in the form of quarterly or twice-yearly dividend payments. Across the entire FTSE 100, these dividends are worth about 3% a year at present.

Thus, although the FTSE 100 index has gone nowhere since 1998, patient investors will have made a modest positive return, thanks to their dividends.

2. Shares can disappoint for decades

Despite their superior long-term returns, shares can underperform other asset classes for incredibly long periods.

For example, between 1968 (the year I was born) and 2008, US investors would have been better off investing in US Treasury bonds than in shares. In other words, over a forty-year period (almost my entire life), American investors would have made more money from boring, safe bonds than from risky, volatile shares.

This seems to contradict against all the lessons taught in business schools about risk and returns.

3. Shares can be extremely volatile

Although shares tend to beat bonds and cash over the very long term, they can display amazing instability along the way. Indeed, since 1999, the FTSE 100 index has behaved like a roller-coaster, as my next table shows:

As you can see, the UK stock market has been up and down like a yo-yo this century.

First, it plunged by more than half, losing 53% of its value by 12 March 2003. Then it more than doubled, rising 105% from this point to 15 June 2007. Then it almost halved again, falling 48% by 3 March 2009. Most recently, it is up 70% from this latest low.

In other words, the market has traced a 'giant W' over the past 11½ years, which shows just how hazardous investing in shares can be!

4. Big businesses can go bust

Often, financial analysts and commentators tend to look at investment returns at the highest level, quoting returns from the FTSE 100 or other major market measures. However, these top-level returns mask a multitude of widely differing outcomes from individual members of these indices.

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At one end of the scale, the best-run, most successful companies may have multiplied their share prices many times over in the past decade. At the other are those companies that didn't survive -- killed off by bad management, stronger competitors, or the credit crunch and economic downturn of 2007/09.

While corporate failures are much more frequent among smaller companies, even big companies, long-lived businesses and well-known names sometimes fall by the wayside. For example, high-street name Woolworths collapsed in November 2008, 99 years after first opening in the UK.

Similarly, FTSE 100 firms Marconi and Railtrack both bit the dust in the Noughties, despite being multi-billion-pound businesses. Also, several of the UK's biggest banks nearly collapsed in 2008, with HBOS and RBS rescued by government bailouts.

Thus, even the biggest companies can be riskier than you can imagine. Hence, don't keep too much of your wealth in one company or market sector. Otherwise, when trouble strikes, your wealth could evaporate almost overnight.

5. Even professional investors foul up

If you don't fancy picking your own shares, then you can delegate this decision by handing your money over to professional fund managers. These highly educated and highly paid individuals buy and sell shares on behalf of investors, sometimes controlling billions of pounds of our money.

However, as with any other aspect of business, fund management has its fair share of losers, as well as winners. The problem for fund managers is that they are at the mercy of their short-term performance. In other words, when their returns start to lag the wider market, investors get cold feet and withdraw their cash.

Recent question on this topic

• bluebell5 asks:

  How do I find out if old shares are worth anything?

  • 
    Daytona answered "[I]The London Stock Exchange offers a very helpful service which should be able to advise you..."
  • 
    MikeGG1 answered "Alternatively, you could contact the company registrars who should be listed on the certificates. ..."
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In the worst cases, this can lead to a run on funds, when prices crash as investors rush for the exits. What's more, this focus on the short term prevents managers from playing a long game and, therefore, reduces overall returns.

Indeed, the majority of fund managers (around 80%) fail to beat the market index which they are benchmarked against. Sometimes, managers do dreadfully, especially when they follow the herd. For instance, some of the technology funds launched during the dotcom boom of the late Nineties went on to lose 90% to 95% of investors' money before throwing in the towel.

Keep a cool head

If you want to minimise your losses from investing, then you should:

1.   Diversify your wealth. In other words, spread your money across shares, property, bonds, cash and other assets, so that you're not overly exposed to one asset or market sector.
2.   Invest regularly. By drip-feeding your money into the market over time, you avoid the risks involved in investing right at the top. Monthly investing will smooth out the inevitable ups and downs.
3.    Love your dividends. Over the decades, the biggest share of your returns will come from reinvesting dividends for further growth. Over time, bigger dividends will make your richer.

Finally, don't be tempted to invest in 'the next big thing'. Often, these 'hot stocks' turn out to be dogs, rather than tomorrow's stars. Investing is a patient, steady marathon and not a reckless sprint, so slow and steady wins the race!

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