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For shares, a record of long-term growth and resilience

05 October 2016 | Portfolio construction

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Key points:

  • Uncertainty is always part of the equation when investing.
  • Vanguard believes equities are a key driver of long-term portfolio growth.
  • Historically, shares have outperformed the other major asset types.

Volatile financial markets test the resolve and patience of even the most pragmatic investors. Why invest in equities when markets are turbulent? Why persist when future returns are expected to be unimpressive?

Put simply, Vanguard believes that equities are a primary driver of a portfolio's growth over time, regardless of the economic or political environment.

In the United States, for example, equities recorded an average return of about 10% per annum from 1926 through 31 August 2016. Comparatively, over the same time period US bonds returned about 5.5% and cash returned about 3.5%1. (These figures assume dividends were reinvested, meaning shareholders chose to use their earnings to buy more shares instead of spending them.)

Of course, equities have suffered through long and difficult periods over the past 90 years, including the 1929 global market crash and subsequent Great Depression. More recently, equities endured the bursting of the dotcom bubble in 2000 and the Global Financial Crisis of 2008–2009. From 1999 to 2009, the annual return of the Standard & Poor's 500 Index, a benchmark representing large US companies, was –3.4% (including reinvested dividends).1

As you've no doubt heard many times, however, past returns aren't a guarantee – or even a predictor – of future results.

Profits and returns

The case for holding shares ultimately comes down to an expectation that the firms issuing those shares will generate profits over the long term and that the price an investor pays for a claim on those profits will be reasonable. Shareholders expect their companies to produce earnings growth, which is collected in the form of dividends, or capital appreciation.

Over time, some firms will experience difficulties, with some even ceasing to operate. Share prices are bid up or down as investors speculate which ones will earn or lose money. Markets are constantly reflecting the latest thinking on companies' prospects.

"The earnings power of companies has grown over time, but there are negatives if you zoom in on particular moments," said Vanguard economist Matthew Tufano. "We don't know how companies are performing in real time, so the market debates their worth. That's why prices jump about."

Considering valuations

Speculation influences stock market returns over shorter periods of time, while corporate profits drive returns in the long term.

Vanguard's 2016 global economic and investment outlook, which was released in December 2015, projects global equity returns over the next decade to be in the 7%–9% range annually, on average. That's somewhat below the historical average and is driven in part by our views on valuations such as firms' price/earnings ratios. (This figure reflects the price investors are willing to pay for £1 of a company's earnings.) Lower expectations for inflation and growth also temper our views on share returns in the future.

"Shifts in valuations tend to explain the majority of equity return volatility over long periods of time," Mr Tufano said. "Trying to predict valuations is very, very difficult. To try and pinpoint an expected return is difficult. That's why our return projections are focused on a range of possible outcomes."

Risks and rewards

A concept known as the equity risk premium explains why shares have been so resilient and why they've outpaced bonds and cash reserves over long periods.

Higher expected returns are the potential reward to investors for weathering the market's turbulence and uncertainty. In other words, investors, logically, would not want to own a risky asset without the expectation of being compensated. The equity risk premium is the amount of return shares have provided over and above that of less-risky assets. By its very nature, however, this phenomenon does not hold in all time periods.

"The equity risk premium exists on average precisely – and only – because it doesn't exist in all circumstances," said John Ameriks, leader of Vanguard Quantitative Equity Group, which oversees many Vanguard equity funds. "In other words, no matter what the time frame, there is a risk of underperformance (and, potentially, dramatic underperformance). It's a 'risk premium', not a 'return premium'."

Equities and the economy

Although Vanguard research points to a fairly weak relationship between performance in the equity market and overall economic growth, the economy and the financial markets are inextricably linked. Corporate profits are rooted in the productivity, growth, consumption decisions and myriad other factors related to the economy and its participants. That said, forecasting share returns is not as easy as predicting economic performance.

"Corporate profits can come from cost-cutting and new technologies," Mr Tufano said. "Earnings can come from overseas, from increasing market share, from price pressures. And that is before you need to take into account the changing prices people would be willing to pay for those earnings."

What's the best guidance for investors as they consider equities? Understand that uncertainty will always be part of the equation when investing in the share market.

"We don't know how much companies will earn at any given point in time, but participating in those profits remains one of the most powerful ways for investors to achieve their long-term goals," Mr Tufano said. "The pursuit of profits is what drives companies forward, and that should ultimately create returns for investors patient enough to assume risk and invest broadly for long time periods."

1 Sources: For US equities, performance was measured by tracking the Standard & Poor's 90 Index from 1926 to 3 March 1957 and the Standard & Poor's 500 Index thereafter. US bonds: Standard & Poor's High Grade Corporate Index 1926–1968, Citigroup High Grade Index 1969–1972, Lehman U.S. Long Credit Aa Index 1973–1975 and Barclays Capital U.S. Aggregate Bond Index thereafter. US cash reserve: Ibbotson U.S 30-Day Treasury Bill Index 1926–1977 and Citigroup 3-Month Treasury Bill Index thereafter.

Important information:

This article is designed for use by, and is directed only at, persons resident in the UK.

This article was produced by Vanguard Asset Management, Limited. It is for educational purposes only and is not a recommendation or solicitation to buy or sell investments.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

The opinions expressed in this article are those of the individual author and may not be representative of Vanguard Asset Management, Ltd.

Issued by Vanguard Asset Management, Ltd, which is authorised and regulated in the UK by the Financial Conduct Authority.

VAM-2016-10-04-3955

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