Share yields remain top but gilts return to favour

Investors have earned a much higher return from shares than gilts, and better protection from inflation too, over many years. Shares will continue to deliver the best results, but the relative performance of gilts is improving, according to a new study. Diane Coyle, Economics Editor, explores a prediction of investment nirvana.

Every year brings a striking reminder of just how well shares do as a long-term investment. pounds 100 invested in equities in 1945, with the annual income reinvested year by year, had grown to pounds 73,657 by December 1997, or pounds 3,372 adjusted for inflation, according to the annual Equity-Gilt Study by Barclays Capital.

By comparison, the total return on pounds 100 invested in gilts - bonds issued by the British government - was a meagre pounds 2,502 in cash terms or pounds 115 in real terms. The same amount held in cash was worth pounds 3,372 at the end of last year, or pounds 158 inflation-adjusted.

Taking account of basic-rate tax just emphasises the superiority of investing in shares. Adjusting for both tax and inflation since 1945, that pounds 100 had turned into pounds 1,417 for equities, pounds 31 for gilts and pounds 50 in a building society account by the end of last year.

Returns in all three categories have improved sharply since 1980, following the runaway inflation of the previous decade.

"The results confirm the importance of equities," said Michael Hughes, group economic adviser to Barclays Capital. A forecast in the 1992 Equity- Gilt Study that the FTSE 100 index would reach a level of 7,000 by the end of the 1990s still looked attainable, he said.

The catch with investing in shares is that the returns are far more volatile than those for "safer" investments. The explanation for their higher return is the greater risk involved.

Mr Hughes played down the danger of a stock market correction in the near future, a fear fuelled by the fact that share valuations are currently high by past standards.

"This begs the question of whether past standards are appropriate for the future," he said, noting that the US and UK stock markets had proved surprisingly resilient to events in Asia.

Both the prospect of inflation remaining low and the likelihood that dividends would grow at a rate faster than the long-run average of 2.2 per cent meant equities could continue to gain ground for some time, he argued.

However, he also said gilts were becoming more attractive relative to equities, with their returns starting to improve this decade after many years of decline.

Not only low inflation but also demographic shifts would boost gilts, for the proportion of middle-aged people saving for retirement is poised to increase during the next two decades.

The study predicted this could take gilt yields to the lowest for 50 years and increase their total returns. The risk premium on investing in shares will shrink, despite the prospect of a high valuation for equities lasting for some years longer.