The long-term benefits of equity investing are clear. A carefully selected portfolio of equities will, over time, offer an investor the opportunity of long-term growth in capital supported by a steady and growing income stream.
Equities provide these benefits by linking investors’ returns to the growth of the underlying company’s profits. Well-managed businesses with consistent profits growth and strong, free cash flow invariably return part of this profit to shareholders through a steadily rising dividend.
Reinvesting these dividends produces the compounding effect that is the secret behind the attraction of long-term equity investment.
Infinite time horizons
For a hypothetical investor with a substantial capital base and an infinite time horizon, a portfolio invested 100 per cent in equites will produce the best long-term results.
The key to this is the time horizon of the hypothetical investor. As the chart demonstrates, UK personal care group Unilever has outperformed wider equity markets, as well as inflation, because growing profits have been returned to shareholders via a dividend payment that has increased by more than 8 per cent a year over the 20-year period.
However, because the period in question includes both the Dotcom bubble and global banking crisis, these returns have been far from linear. Despite producing a near 1,000 per cent total return for investors, there have been short periods within the 20 years when an investor would have experienced a capital loss.
Declining global growth, excessive market valuations, extraneous geopolitical shocks and rising interest rates are just some of the factors that create the disruptive equity markets events that lead to painful losses of capital during some periods. For investors in well-managed companies, such as Unilever, these losses will be temporary, but ill-advised investments in highly leveraged companies with weak balance sheets can and do lead to permanent loss.
For real-world investors with a finite time horizon, trying to balance the need to both protect and grow capital, an equity-only investment portfolio is almost certainly not the answer. Unless an investor can consistently demonstrate abnormal skill – or luck – in timing the entry and exit points of the equity market, most are better advised to reduce their portfolio risk by other means.
Professional investors will often refer to the diversification benefits of holding multiple, uncorrelated assets in a single portfolio. An asset is deemed to be uncorrelated – or exhibit low correlation – if its typical return differs from other assets within a portfolio under identical market conditions.
- For a hypothetical investor, a portfolio invested 100 per cent in equities will produce the best long-term results.
- The average investor with a shorter time horizon prefers a diversified portfolio.
- Multi-asset funds are one way of getting this diversification.
Adjusting for currency
In this context, diversifying UK equities by investing in companies listed in the US or Europe, for example, achieves little, as their currency-adjusted returns are very similar. So if equities do the long-term heavy lifting in a portfolio – and most equity markets (ex currency) are highly correlated – it is the other asset classes available to an investor that can help smooth the path of returns in attempt to make them more linear.
Traditionally investment managers would use a blend of government and corporate bonds, commercial property, cash and commodities to offset the volatility of returns that come from the equity component of the portfolio.