Who's afraid of the big bad bears?

Shares can fall as well as rise, but as we discuss here and opposite, investors should not be daunted
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We Are only three months into the year and the stock market is up 7 per cent. This sort of growth is not untypical. Anyone who had the luck or foresight to put money into a spread of shares 20 years ago would have seen their value rise 11-fold, that is to say pounds 100 would now be worth pounds 1,100.

Nor have such returns been different from other parts of the world. The American stock market has been similarly profitable, while the dynamic economies of the Pacific Rim have produced more spectacular returns. The Hong Kong stock market rose 29-fold in the 20 years to 1995.

A consequence of this is that a whole generation of investors has grown up not knowing how bad things can get. Prices can fall and fail to recover for a long time: 1973 and 1974 saw one of these bear markets when prices fell 33 per cent and then took another 55 per cent tumble.

It is tempting to conclude that those with no memories of bitter stock markets will be condemned to experience them in the future. However, even if this were the case, it does not necessarily detract from the long- term benefits of being in the stock market. A sweeping view of returns from the US stock market since 1915 tells us that reliving history may not be so awful. By dividing recent history into 10-year periods, two observations spring out.

The 10 years from 1985 to 1995 were the best by a big margin. The 12.7 per cent average year-on-year growth of US shares was remarkable and was also achieved without the fluctuations that so often characterise stock markets.

Almost all of the other periods were pretty good. Only in two of them (1926-35 and 1966-75) did the stock market finish lower than when it started. A similar study for the UK shows that shares have consistently outperformed cash and gilts.

But exactly because the recent past has been so outstanding it is difficult to escape the feeling that the future, say the next 20 years, will not be nearly as good for shares. Returns may well regress to their long-term average, which is 9 per cent a year before inflation in the UK and 7 per cent in the US.

Additionally, future returns may not be as consistent. In the 22 years since the deep bear market of 1973-74, UK shares have finished lower on the previous year just three times and in the US four times. Yet in the 80-year history of fully authenticated US share returns, that market has had 27 down years. In the UK the ratio is similar: 28 down years out of 78. In other words, loss-making years crop up at the rate of one in three. All of which asks the question: what's happened to the expected losing years in the past two decades? The answer may be that the long- run averages are just waiting to reassert themselves.

But increased fluctuations in share returns will matter little for an investor with a long investment horizon. For evidence, take returns generated in the UK over the past 20 years or so.

Imagine that two investors each bought a batch of shares during 1974 when the UK stock market plunged. Assume, also, that one investor bought when the market was at its 1974 peak (that is, before it crashed) and the other bought at the 1974 nadir.

After one year the investment performance of the two would be vastly different. The unlucky investor might, at worst, have been carrying a 59 per cent loss. The lucky investor who bought at the bottom could have been looking at a profit of 159 per cent profit within the year. But as the investment horizon lengthens, two things happen: the unlucky investor moves into profit and his profit stabilises; and the gap between the best possible and worst possible returns narrows and stabilises. These results are summed up in the table. It is important to realise that 1974 was deliberately chosen as a freakish year, freakishly bad from the point of view of what we are trying to prove: that satisfactory returns are available for all investors in shares who are prepared to bide their time.

Granted, the future does not have to be like the past. But if it is worse than the worst of the past then investors will have cause to feel hard done by. Indeed, it may well also mean that other events are shaking the UK economy that leave worrying about share values as the least of investors' worries.

Philip Ryland is author of 'The Economist Pocket Investor' and deputy editor of 'Investors Chronicle' magazine. The 'Independent on Sunday' has 12 free copies of the book to give away to readers. Send a postcard with your name and address to Steve Lodge, Personal Finance Editor, Independent on Sunday Pocket Investor Free Book Offer, 1 Canada Square, Canary Wharf, London E14 5DL. Otherwise, the book is available at pounds 10.99 from bookshops or from the publishers, Profile Books, on 0171 486 6010.

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