Bloomsbury Financial Planning

Millions of investors who have suffered a "lost decade" of stock-market returns are urged this week to keep faith with equities. 

The Barclays Capital Equity Gilt study, which analyses returns from British shares going back 110 years, will confirm that the decade ending last year was the second worst on record.

However, battered investors would be wrong to lose faith: prospects for future returns, on some measures at least, are at their best for a generation.

The FTSE 100 has fallen 28% over 10 years and is down 1% even with dividends included. The picture is slightly better if you take the UK stock market as a whole, including smaller companies — but not much. It returned just 1.05% a year between 1998 and 2008 in nominal terms, according to Barclays Capital. Only the decade ending in 1974 saw a weaker return at 1.02% a year.

Returns look even worse after inflation: the UK stock market is down 1.4% a year in real terms over the past decade, according to Paul Marsh, emeritus professor of finance at the London Business School.

Investors can take comfort from the fact there have been worse periods in history once inflation is factored in.

“In real terms, the decade to the end of 2008 was only the ninth-worst on record for the UK,” said Marsh. “The worst was that ending in 1920, which covered the first world war and a period of relatively high inflation. Real returns fell 5.6% a year or 44% overall.”

Many investors are questioning the rationale behind equities, with savers pulling millions from equity Isas last year. Yet analysts urged investors to stick with shares.

Tim Bond at Barclays Capital and one of the report’s authors, said: “As a natural reaction to this long phase of poor returns, there has been much talk of the death of the equity ‘cult’. While such talk may accurately represent investors’ disenchantment with equities, it is most likely a poor forecast for future returns. Prospective returns from equities are at the most attractive levels seen for some 20 years in the US and over 25 years in Europe and the UK.”

Marsh agrees there are grounds for hope. “Good can come out of recession. Balance sheets can be strengthened, and there can be a process of corporate renewal.”

We spoke to the experts to learn some lessons from the lost decade.

Ten years is not enough

Financial advisers generally urge clients to invest for at least five years, but the last decade suggests even 10 years is not enough.

Marsh said: “I would never advise an investor that five years was adequate. If people can’t afford to lose money over five years they should avoid shares, it’s as simple as that. Your time horizon should be more like 20-30 years, so you should be starting your pension in your twenties or thirties.”

He pointed out that the longest period in UK history when you would have made negative real returns from equities was 22 years — between 1900 and 1921. In America, the longest period was just 16 years.

Other countries have suffered longer periods of negative returns — in Japan, there was a 51-year period over which investors lost money, and in Germany you could have made nothing over 55 years of investment — but these were special cases because of the second world war.

“Bearing in mind that nothing can make shares ‘safe’ over any time horizon — there is always going to be risk — the balance of probability and the record of history is on your side. They suggest that over the long run, equities will outperform other assets.”

Over 50 years, equities have delivered the best returns of any asset (property excluded) with a real return of 5.7% a year compared with 2.3% from gilts and 2% from cash, Barclays Capital said. Hold equities for just two years, and they beat cash in 72 out of 108 years — meaning your chance of outperformance was just 67%. Extend the holding period to ten years, however, and you have a 92% chance of beating cash.

Valuations are more important than profits

So why did the UK stock market perform so badly over the past decade? “The overvaluation was the most extreme of the past century and indeed of recorded stock-market history,” said Bond at Barclays Capital.

“The brutal lesson we can glean from the past ten years is that valuations, rather than macroeconomic conditions or the progress of corporate profits, are the core determinant of equity-market returns.”

Bond bases his conclusion on a measure of valuation called Tobin’s Q but ordinary investors could look at a more simple indicator such as the price/dividend ratio. This is calculated by dividing the price of a stock by the annual dividend paid on the share. It signalled the market was overvalued in 1998, but now points to annualised returns of 11.2% a year until 2018.

Spreading assets really does work

Marsh said: “Having a diversified portfolio is not likely to improve your expected returns, but it will help to reduce risk to a level you can live with.”

The average UK equity fund is down by 1.99% over 10 years, according to figures from Chelsea Financial Services — better than the market, but still negative.

By contrast, if you had held a balanced portfolio over the past 10 years with, say, 5% invested in commodities, 5% in global emerging markets, 20% in global equities, 10% in property, 15% in bonds, 5% in gilts and 40% in UK equities, you would have seen a return of 27.8%. Hardly exciting, but you would be feeling better than someone with all their money in the stock market.

Top managers can do even better - if you're lucky

Investors who have been fortunate enough to pick the top managers over the past decade have easily beaten the market. Andrew Green, manager of GAM UK Diversified, has produced a stellar return of 180% over the past 10 years, with Neil Woodford not far behind with a gain of 145% for his Invesco Equity Income fund.

The internet has made it easier than ever to assess which managers may be most likely to beat the market. Citywire.co.uk, for example, assesses the risk-adjusted returns of 1,000 managers over the past three years — essentially showing how much “added value” they have delivered. About 20% achieve a rating, and about 5% get the top AAA accreditation.

However, there is a strong argument that the average investor has little chance of picking a market-beating manager, so you may as well cut costs and use inexpensive tracker funds.

Bloomsbury Financial Planning, for example, builds one of seven model portfolios spanning equities, emerging markets, property, commodities and bonds. It automatically sells assets if they perform well and move above your fixed allocation.

It uses institutional tracker funds or exchange traded funds (ETFs) — a type of tracker than is traded like a share. For exposure to property, for example, it uses a Barclays Global Investors’ ETF. For commodities it uses Lyxor.

Hold your nerve for double-digit returns

Getting out of equities altogether now means any losses will be crystallised, and there is plenty of evidence to suggest that remaining invested in turbulent times is the most sensible strategy.

According to analysis by fund manager Fidelity International, which studied every complete 10-year period between 1899 and 2007 using data from the Barclays Capital Equity Gilt study, in 99 ten-year periods, the real value of shares has fallen by more than the most recent decline on 19 separate occasions. A spokesman for Fidelity International said: “Buying shares at the end of a lost decade as bad or worse than the past 10 years has failed on only one occasion since 1899 to at least double the purchasing power of the money invested over the following 10 years.

“Only a very confident investor would bet against an 18-1 record.”

Nervous investors particularly worried by volatility can also help smooth out peaks and troughs with regular savings. This avoids the risk of bad timing — putting a lump sum in just before prices fall — and goes some way towards removing the stress of trying to guess the market’s next move.

Hold fire on gilts - for now

While advisers generally recommend a balanced portfolio, there have been better times to buy gilts. Ten-year UK government bonds are currently yielding 3.5%, having started the year at 3.32%, meaning prices have fallen.

Patrick Gordon at broker Killik said: “We believe that the ‘do whatever it takes’ policy actions of the authorities to avoid deflation and attempt to reignite economic growth will ultimately be inflationary. This environment would be disadvantageous to holders of conventional gilts.”

For investors who still want exposure, but are concerned about inflation, Killik recommends index-linked Treasury stock. While not as attractive as it was a couple of months ago, the 2.5% Index-linked Treasury Stock 2016 — assuming inflation at 3% — still provides a real yield of about 1.6%.

But stock up on bonds

Corporate bonds are cheaper than at any time since the 1930s and many experts believe they are going to be one of the top-performing asset classes over 2009.

Investment-grade corporate-bond yields are at 7.1%, making them much more attractive than their gilt-edged counterparts.

Martin Bamford of Informed Choice, an adviser, recommends the M&G Corporate Bond and the Old Mutual Corporate Bond funds.

Hold off on commodities

The picture for commodities isn’t looking bright.

Investment bank UBS last month cut its forecasts for commodity prices in 2009 by an average of 37%.

Most mainstream collective funds which invest in commodities focus on companies associated with mining and the petrochemical industry.

As oil prices have plummeted, the share prices of these companies have fallen, too, with a corresponding drop in the value of collective funds.

Don't cash in all at once

Bamford said: “It is only really a lost decade if you have to come out of equities entirely now. For investors with a reasonable term left before their retirement or other financial objective, a gradual phasing away from equities can make more sense.”