How to invest in uncertain times

With the world deep in recession, you'd have to be mad to put your cash into shares. Wouldn't you? In fact, argues, Hamish McRae, there's rarely been a better time to dive into the markets

Britons are saving again. Amid the clamour about the G20 meeting, the fiscal stimulus, "qualitative easing" and all that, something radical has been taking place. The household savings ratio shot up to nearly 6 per cent in the last quarter of 2008 – a fraction under its long-term average. The previous quarter it was less than 2 per cent.

Often ordinary people are more sensible than their political leaders, or indeed their bankers. During the long boom, individuals, like the Government, borrowed big to maintain their spending. But they started to cut back on credit card debt some months ago and now have been using the cut that many have started to receive in their monthly mortgage bills to rebuild their savings.

Part of the motive, presumably, is fear of unemployment, and the social and human costs of the economic slowdown are shattering. But part is perhaps a return to what you might call pre-boom values. The idea that people should put something aside for the future is just as embedded in our human psyche as the I-want-it-now attitude of the past few years. Pity it took a recession to bring us back to earth.

But how to save effectively in a world where returns on cash are so low, where house prices are still falling and where the stock market has had the most catastrophic decade since the 1970s?

There is no easy answer to that question, no "get rich quick" solution. But there are pointers towards a "get rich slow" outcome, some of which are explained here. The good news is that for people with savings and a longer time horizon, it is, at worst, an OK time to acquire assets and at best, a once-in-a-generation opportunity to do so.

There are two basic rules to all investment. One is that tax advantages are almost always worth taking; the other is to spread risk. The tax point is easy to make. A higher-rate taxpayer puts an extra £1,000 into his or her pension pot. That costs, after tax relief, £600. Most of it goes into equities – and the stock market promptly falls by another 40 per cent. That would be at the outer limits of the possible, given that the falls of the past year have been worse than anything that happened in UK finance – even in the 1930s and 1940s. But the pot would still be worth at least the £600 and the taxpayer would be square – actually probably better than square because there would be some dividends, and employers will sometimes add to the payment. There are disadvantages of putting money into pensions, because it is locked up, but the tax advantages are such that it is nearly always worthwhile.

The spreading risk point comes in two halves. The first is obvious. No one should have all their eggs in one basket. If we all had 20-20 hindsight we would have sold any shares we had at the end of 1999 and bought property with the money. Then we would have sold the property in the summer of 2007 and put the money into US government securities. And then now... well, that is the problem, we don't know what to do now. You can only play the game backwards. But if, back in 2000, we had held one third of our money in shares, one third in property and one third in US treasuries, we would still be decently ahead. One pot would be down but the other two still up.

The other spreading risk point is time. Take a single investment category, UK shares, and take the awful period from the end of 1999 to today. Assume you invested steadily throughout the period, putting something in each month. You might have put some in when the FTSE 100 index was around its peak, at 6950, but some would have gone in below 4000 during 2003, and some more in the past few months. And – the key point – you would have bought more shares when the price was low than when it was high. You would still have lost money because this has been a very bad period, but if you reinvested your dividends, on my quick tally, the index only needs to get back to about 4700 for you to be ahead. We are not there, of course, but that is not an implausible target for the next couple of years.

There are two further points to bear in mind. One is that over a long period, asset values revert to a mean. UK house prices have historically traded at around 3.5 times average earnings. Apply that rule and it is clear that prices were cheap in the 1990s, as that ratio dipped below three times, that they were expensive in the late 1980s when they reached nearly four times earnings and terribly expensive in 2007, when they reached nearly six times earnings. Now they are heading back to four times earnings, so are still a bit high, but no longer absurdly so. Given the rate at which house prices are still falling, in another year they will start to look cheap. You can apply the same logic to share prices, using the measure of the price/earnings ratio, and conclude that they were far too high in 2000, and rather too high last year, but now are again pretty cheap.

This does not say what will happen to prices in the future; all it says is that there are probably rather good times to buy any particular asset and probably rather bad ones.

The final point is that we are human beings and our strange and wonderful species has a strong group identity. We tend to think alike, and as a result get carried away with bouts of excessive enthusiasm and excessive pessimism that are hard to escape. Back in the days of the dotcom boom, everyone was carried away by the notion that the new communications technologies would change our lives and make our fortunes. They did the first but failed to do the second.

In 2007, everyone thought the housing boom would continue – or at least many people did. Our then-chancellor certainly thought growth would continue, though a few of us warned there would be some sort of downturn.

Now the reverse is true; the fashion is to claim this is the worst economic catastrophe since whenever. Those of us who think there will be a recovery at the latest by 2010 and that this downturn will be no worse than the 1970s or early 1980s are criticised for our supposed optimism. Try and hang on to that as the gloom-mongers of the G20 have their moment in the sun this week.