Why equities beat cash and gilts hands down

Magnus Grimond delves into a new study by BZW which makes a strong case for share investment

The latest Equity-Gilt Study from Barclays de Zoete Wedd, the investment bank, always makes fascinating reading. But the publication of this annual look at the performance of equities, gilts and cash over most of the years of this century holds more than usual interest this year as stock markets on both sides of the Atlantic hit new all-time peaks.

Investors mesmerised by the heights equities are reaching would do well to take stock of how shares have performed over the long term and whether any lessons can be learnt about the future, particularly in view of the many Jeremiahs forecasting a crash in 1997.

First, the conclusions of the past. It will probably come as little surprise to most seasoned investors that equities have massively outperformed both gilts and cash since the end of World War One, when the BZW study begins. From 1919 to 1996 shares have turned in an inflation-adjusted "real" return of 7.86 per cent a year, against just under 2 per cent for government bonds and less than 1.5 per cent for cash. In the words of Michael Hughes, BZW's head of economics and strategy, investors are being paid a 5.9 per cent premium for the extra risk of holding shares.

This margin looks high, given the history. For one thing, there have been times when cash has hardly been as safe as houses. During the last war it turned in a negative annual return of 2.69 per cent, while anyone who kept their wealth in cash during the decade covering the 1970s would have lost around 28 per cent of it in real terms.

But the risk of holding equities also looks grossly over-stated, at least over long periods. BZW calculates that the chance of equities outperforming both gilts and cash is around 70 per cent over two years, rising to a massive 96 or 97 per cent over 10 years. That said, there have been quite lengthy periods when investors have needed strong nerves: during the late 1930s and the 1970s, shares produced several consecutively negative years, with 1974 recording a whopping 58 per cent loss.

The facts, however, speak for themselves: pounds 100 put into the stock market in 1918 would now be worth pounds 786.30, whereas a similar investment in gilts would have been virtually wiped out, being worth just pounds 3.10 now.

So the first lesson from BZW is that everyone should be in equities if they want to protect their wealth. The second is that, if they can, they should reinvest the income. Ploughing back dividends into the stock market would have turned that same pounds 100 into pounds 36,528 over the past 78 years, with around two-thirds of the return coming from the dividend yield. Including dividends, it means higher rate tax payers have enjoyed a real annual return of 3.9 per cent, comfortably above the average 2.1 per cent growth in the economy.

Clearly, however, wealth is not just for hoarding and most investors do not operate on the three- or four-generation timescale of the BZW study. There are times when selling equities is more profitable in the short term than holding them, so Mr Hughes' conclusion that "investment is more about direction than valuation" seems axiomatic - if an investor knows the direction of the next trend in the market, he can clearly ignore any fundamental valuation methods. But his point is that turning points tend to be dictated by competition for money between the economy and the stock market, which forces up interest rates, rather than any sudden over- or under-valuation in itself.

The $64,000 question is what this means for the market. The current upswing has been running since 1981, according to BZW, when long bond yields topped out. "When you have a very long-term bull market, it's unlikely to end with a whimper. In other words, you get things so overvalued that the correction is normally quite severe," Mr Hughes warns. But he reckons we will not be at that stage until the end of the decade.

As he points out, equities have sustained periods of apparent over-valuation lasting several years in the past. The chart, which shows actual share prices against three different fair valuation methods (plotted in the grey area), suggests London is historically very over-valued.

But valuation is a moving target and the UK has been going through a period of vast secular economic change. Price-earnings ratios, typically ranging between six and 10 in the 1970s, have moved up to between 14 and 18. Likewise, the much-quoted gilt-equity yield ratio was under one until the 1960s, rising to around 2.5 in the early 1970s, before steadily falling in the 1980s. If the Government can sustain its 1-4 per cent inflation target, Mr Hughes reckons it could fall to 1.3 in the future, which would be good news for equities.

And there lies the key. Equities, gilts and cash all perform better when inflation is below its long-term trend, with shares doing particularly well if growth is also above trend. Mr Hughes sees no significant upswing in interest rates on the horizon to upset the apple cart.

His view is not shared by Bob Farrell, chief investment adviser to US investment bank Merrill Lynch. Earlier this month he forecast a major correction in the US market this year. Even if he is wrong, the future direction of equities looks more finely poised than it has been for many years.

Start your day with The Independent, sign up for daily news emails
News
i100
Arts and Entertainment
Billie Piper as Brona in Penny Dreadful
tvReview: It’s business as usual in Victorian London. Let’s hope that changes as we get further into the new series spoiler alert
Life and Style
A nurse tends to a recovering patient on a general ward at The Queen Elizabeth Hospital in Birmingham
health
News
science
Arts and Entertainment
No Offence
tvReview: No Offence has characters who are larger than life and yet somehow completely true to life at the same time spoiler alert
News
Chuck Norris pictured in 1996
people
ebooks
ebooksA celebration of British elections
Arts and Entertainment
Sarah Lucas, I SCREAM DADDIO, Installation View, British Pavilion 2015
artWhy Sarah Lucas is the perfect choice to represent British art at the Venice Biennale
News
A voter placing a ballot paper in the box at a polling station
i100
News
people
Arts and Entertainment
The Queen (Kristin Scott Thomas) in The Audience
theatreReview: Stephen Daldry's direction is crisp in perfectly-timed revival
Sport
football
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SThree: Trainee Recruitment Consultant - Swiss Banking and Finance

£20000 - £25000 per annum + Uncapped commission: SThree: Can you speak German,...

Ashdown Group: Marketing Executive - 6 month FTC - Central London

£25000 - £30000 per annum + benefits: Ashdown Group: An exciting opportunity f...

Ashdown Group: Junior Project Manager (website, web application) - Agile

£215 per day: Ashdown Group: Junior Project Manager (website, web application ...

Guru Careers: Software Engineer / Software Developer

£40-50K: Guru Careers: We are seeking an experienced Software Engineer / Softw...

Day In a Page

General Election 2015: Ed Miliband's unlikely journey from hapless geek to heart-throb

Miliband's unlikely journey from hapless geek to heart-throb

He was meant to be Labour's biggest handicap - but has become almost an asset
General Election 2015: A guide to the smaller parties, from the the National Health Action Party to the Church of the Militant Elvis Party

On the margins

From Militant Elvis to Women's Equality: a guide to the underdogs standing in the election
Amr Darrag: Ex-Muslim Brotherhood minister in exile still believes Egypt's military regime can be replaced with 'moderate' Islamic rule

'This is the battle of young Egypt for the future of our country'

Ex-Muslim Brotherhood minister Amr Darrag still believes the opposition can rid Egypt of its military regime and replace it with 'moderate' Islamic rule, he tells Robert Fisk
Why patients must rely less on doctors: Improving our own health is the 'blockbuster drug of the century'

Why patients must rely less on doctors

Improving our own health is the 'blockbuster drug of the century'
Sarah Lucas is the perfect artist to represent Britain at the Venice Biennale

Flesh in Venice

Sarah Lucas has filled the British pavilion at the Venice Biennale with slinky cats and casts of her female friends' private parts. It makes you proud to be a woman, says Karen Wright
11 best anti-ageing day creams

11 best anti-ageing day creams

Slow down the ageing process with one of these high-performance, hardworking anti-agers
Juventus 2 Real Madrid 1: Five things we learnt, including Iker Casillas is past it and Carlos Tevez remains effective

Juventus vs Real Madrid

Five things we learnt from the Italian's Champions League first leg win over the Spanish giants
Ashes 2015: Test series looks a lost cause for England... whoever takes over as ECB director of cricket

Ashes series looks a lost cause for England...

Whoever takes over as ECB director of cricket, says Stephen Brenkley
Fishing for votes with Nigel Farage: The Ukip leader shows how he can work an audience as he casts his line to the disaffected of Grimsby

Fishing is on Nigel Farage's mind

Ukip leader casts a line to the disaffected
Who is bombing whom in the Middle East? It's amazing they don't all hit each other

Who is bombing whom in the Middle East?

Robert Fisk untangles the countries and factions
China's influence on fashion: At the top of the game both creatively and commercially

China's influence on fashion

At the top of the game both creatively and commercially
Lord O’Donnell: Former cabinet secretary on the election and life away from the levers of power

The man known as GOD has a reputation for getting the job done

Lord O'Donnell's three principles of rule
Rainbow shades: It's all bright on the night

Rainbow shades

It's all bright on the night
'It was first time I had ever tasted chocolate. I kept a piece, and when Amsterdam was liberated, I gave it to the first Allied soldier I saw'

Bread from heaven

Dutch survivors thank RAF for World War II drop that saved millions
Britain will be 'run for the wealthy and powerful' if Tories retain power - Labour

How 'the Axe' helped Labour

UK will be 'run for the wealthy and powerful' if Tories retain power