Tuesday, 26 February 2013

Invest for the Long Term

In my article keep it simple I listed a few of my basic rules for successful investing and said I would look at each one in a little more detail. 

The first rule of investing for me (and I’m sure many others) is timeframe - the longer you have to invest, the better chances you have of riding out the long term cycles and ups and downs of the markets.

If you may need your spare money for other purposes in the next 5 years - deposit on a house purchase, holidays, new kitchen etc. then investing on the markets, however tempting, is probably best avoided. Put your spare cash in a savings deposit account.

If you are thinking longer term - minimum 5+ years and preferably 10+ years - your investments will have a much better chance of providing better returns than your average cash deposit savings account.

Of course, at any given moment in time you can always make out the case for not investing - in the 1990s there was the global recession, the Asian financial crisis and the irrational exuberance culminating in the so called ‘dot com’ crash of 2000. In the past decade we have witnessed the terrorist attack on the World Trade Centre, the military conflicts in Iraq and Afghanistan, hurricane Katrina, the credit crunch and sub-prime mortgage crisis, the European sovereign debt crisis and the problems with Greece, Spain, Ireland and Portugal. In the past week concerns have been expressed about the UK economy and we have lost our AAA credit rating with Moody‘s.

Throughout this seeming economic and political turmoil, stable well-run companies have survived and even thrived, dividends have continued to be paid - with a few notable exceptions - and the markets, although a little more volatile at times, have continued their upward trajectory. It seems no matter what the crisis, and no matter how low the markets fall, they always bounce back - sometimes quite dramatically as we have seen with the FTSE in the past couple of months.

I will cover the important area of asset allocation - what mix of equities, bonds, commodities, cash etc. - in a future post. For now, lets assume you are investing in equities (stocks and shares).

Returns for Equities

(click to enlarge)
Numerous academic studies over the years have shown that over the long term, investment in shares will provide a superior return to both cash and bonds. The very long term (since 1900) average for shares, after inflation, is just over 5% per year compared to under 2% for bonds and just over 1% for cash.

Equities have been the best place to invest in 6 out of the past 7 decades, however for the last decade 2000 - 2010, equities were beaten by both cash and bonds.

I won’t go into more detail here but for those interested, look up Credit Suisse Annual Yearbook and also Barcap Equity Gilt Study.

So, on average, you will get say 3% - 4% more every year investing in equities than you would get on cash deposits. How does this translate in returns over, say 20 years?

As an example, lets take a lump sum of £10,000 and drip feed £100 per month over the 20 years - a total investment of £34,000. I have assumed an average rate of 3% on a cash deposit and 6.5% on equity investments. Using the useful calculator tools on Candid Money  the return on the cash deposit would be £50,828 and the return on the investment would be £77,636 (after allowing for 0.5% investment charges).

Patience

Be aware that these figures are based on long term averages - over shorter periods, equities may not produce the goods as we have seen for 2000 - 2010. The FTSE 100 has only recently returned to the levels last seen before the credit crunch in 2008 and has still to reach the dizzy heights of just under 6,930 reached in December 1999 (I know I should have sold those dot.com shares!).

This is why I suggest a more realistic time frame of 10+ years. In an age of instant gratification, it can be difficult to make a long term commitment but in the words of legendary investor Warren Buffett
“The stock market is designed to transfer money from the active to the patient”.

Of course, investing for the long term over many years will only be a part of the solution - you could be the epitome of the patient long term investor - a Zen master in the art of the long wait, but if you are in the wrong type of investment and you are paying high charges, your returns will be adversely affected.

I will take a look at the importance of costs and charges in the next instalment.

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