Back to the future
Readers of 19th century novels will know that the key requirement of a satisfactory bridegroom was a certain yet safe income, and this came from the ownership of first-world government bonds. This simple world came to an end with the 20th century; rising prices associated with financing wars, and increased government manipulation of the economy to bring about desirable social ends – such as the alleviation of poverty or greater economic growth – made fixed income investments dangerous loss makers.
But, bridegroom or pensioner, the need for income never went away. By the 1950s, a diversified portfolio of shares was considered to be the best way of providing an income that would offset the problem of inflation. For those lacking a stockbroker, or fearful of stock markets, mutual funds [unit trusts] sold by insurance salesforces offered apparently easy ways of making money in this inflationary but fast-growing world of economic opportunity.
This cult of the equity ensured that, up to 2008 and the banking collapse, equities yielded less than bonds, despite their greater volatility and real risk of dividend cuts or even bankruptcy. However it was also in the 1980s that Paul Volcker, then head of the US Federal Reserve [the US central bank], persuaded investors that he was determined to drive inflation out of the system.
Such is the irony of financial markets that, thanks to Mr Volcker, bond investors have actually done better than most equity investors over many of the last 30 years. It is this history, plus quantitative easing, that has pushed bond prices into bubble territory.
Plus ça change...
Those financial certainties have gone away. The efficient market hypothesis has proved a chimera, emerging markets a fast-fading dream of simple riches, and now there are doubts about the certainty of regular, annual economic growth, the foundation of corporate profits and dividends. So it is no surprise that GMO, the well-respected Boston-based asset manager, reckons that US returns from cash, bonds and shares over the next seven years will be lower than inflation.
So far the 21st century has returned actual losses to UK equity investors. Savaged by the bear markets in 2001/2 and 2008/9, annualised equity total returns from the start of 2000 to 2014 have only been 1.2 per cent compared with 2.5 per cent on bonds, and both beaten by inflation of 2.7 per cent, according to the Credit Suisse Global Investment Returns Sourcebook 2014.
It has been worse for private investors; research shows that they enter markets late in the up-cycle, and disinvest too late in the downswing, so worsening the returns shown above.
Private investors have no chance of matching the reaction times of professionals, but they have other advantages. The first is time, and the second the ability to make their own decisions without the need to please superiors. Sadly, most ignore these but, properly understood, they can enable investors to outperform markets and many professionals.
Understanding compound interest
Dividend income is such a minor part of a share’s value that it is easy to ignore it and assume that the real growth comes from buying when low and selling when high. Looking at the price movements of any share over 12 months or longer encourages this belief, and also the conviction that it should be easy to do this. This is an assumption encouraged by professionals, who benefit from the income generated by buying and selling.
But that insignificant dividend becomes much more important as it multiplies three or four times over ensuing years, interest is earned on the accruing balances, and especially so if that dividend is increased as a percentage of the nominal price of the share. An increased dividend itself increases the market price of the share; other things remaining equal, the new price will adjust to the earlier price/earnings ratio and dividend yield of the share before the increase.
The opposite, of course, happens with a dividend cut, which is why boards of directors think hard before increasing the dividend, lest they have to cut it later. It will take years before investors trust Tesco again after its savage cut to the dividend this autumn. Equally, it is why those investment trusts that have increased their dividends year after year are so treasured by their shareholders.
In the end, it is the adding together of all those tiny yearly dividends, as well as the compounding effect of interest upon interest payments, that increase the value of shares – analysis proves some
90 per cent of the capital gains that investors long for, and fail to achieve by short-term dealing, come from reinvested dividends.
Keeping costs down
Every time a security is bought and sold, money is lost. Some is the market spread between buying and selling price, some is stamp duty or other forms of tax, and more is the cost of commissions. On top of that, most investors must pay management fees, and sometimes several as with ‘funds of funds’ and even more esoteric formulations designed to avoid market volatility. The costs mount up; if markets are producing annual returns of 5 per cent there is something left for the investor but, if anything less than this, the returns are not worth the risk.
Private investors do not suffer the pressure of professional fund managers to do ‘better’ than the opposition, or to be in the currently fashionable sectors of the market. They can set a strategy and allow time (and compound interest) to work its magic.
Nor should they be affected by market panics; when they come – and they always do – the best bet is to stop reading the financial papers.
Finding the best
Moreover, and despite the rulings of the regulators, past performance does influence future performance. Mostly, this is not due to genius but process – even for such an outstanding investor as Warren Buffett. It is hard for unit trust managers to do consistently well, but that is because the main driver for most is marketing performance, and not investment management.
The few that excel are those with such a reputation in the market that they can ignore such internal concerns. Investment trust managers have no such competing concerns. They can concentrate on stock picking, while knowing that their board of directors are both supportive and critical of their execution of an investment strategy agreed by all. But not all boards are as conscious of their duties as they should be, and nor are all managers as good as they ought to be.
So selection is as important among investment trusts as it is among other companies directly quoted on the stock exchange. Strategies differ, but most investment companies can choose whatever choice of asset they consider most suitable at the time to achieve their stated investment objectives, whether bonds, shares or cash.
This is an important resource when markets are threatened with unknown risks, together with threats of war, terrorism and economic failure. Moreover, as incorporated companies investment trusts can build up reserves to use in paying dividends when times are hard and profits difficult to find.
Nothing can save investors from market collapse, but an increasing income helps dull the pain.
