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Has the investment world changed?

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By Expert Panel 22.10.2012

By Wealth Foundations

Will shares continue to outperform cash?

We use the chart below, showing a comparison of the growth since 1926 of a $1 invested in the US share market  with a $1 invested in cash, to reveal a couple of key historical insights about investing, including:

- There was a huge opportunity cost to investors of “playing it safe”, by holding all their investment wealth in cash; and

- The returns to shares were anything but smooth with the market often taking many years to recover its previous highs after a major downturn e.g. the US share market is still a long way from recovering its peak of March 2000.

 

Has the investment world changed?

A lesson we think should be drawn from the chart is that the higher expected returns from shares are only available to patient investors.

However, driven by the economic “gloom and doom” since 2007, a response we often receive to the chart is that the world has changed – the past is irrelevant. Share returns will be permanently lower, while volatility will remain. The “safe” option of cash (and other defensive assets) provides a certain return and will prove relatively more attractive in future.

These types of views raise two issues that we explore in this article:

  1. Does recent share market return experience suggest the “world has changed”; and

  1. Is cash really “safer” than shares?

Past investment returns indicate a wide range of possible futures

The table below provides some relevant statistical information for US shares and cash for the 86 year period from July 1926 – June 2012:

Investment

Compound Annual Return (After-inflation) %

Annual Average Return(After-inflation) %

Volatility %

Shares

6.7

8.3

19.3

Cash

0.5

0.5

1.8

 

If we are prepared to assume that returns in the future will exhibit the same characteristics as those shown above, a volatility of 19.3% for shares, for example, implies that for any particular future year there is a 68% chance that the actual share market return will vary between – 11.0% and +27.6%.

The information in the table can be used to simulate thousands of possible future returns and paths for the growth of a $1, using a technique called Monte Carlo. It enables us to see the potential variation in wealth outcomes on the assumption that the “world hasn’t changed”.

The chart below shows the results of 5,000 such simulations for a $1 investment in US shares for 86 years, compared with the actual experience from June 1926 to June 2012. The range of potential outcomes is huge.

Has the investment world changed?

5% of the simulations reveal real growth in excess of the green line (i.e. the 95th percentile), with 5% below the blue line (the 5th percentile). The 5th percentile also implies that if you want to be 95% confident of having a positive real return from shares, you need to be prepared to invest for a period exceeding about 21 Years. If you want to be 99% confident, about 40 years!

So, even based on the share market behaving consistently with the past 86 years, it is possible that you could have less than what you started with after investing in the share market for 20 years. Given this, the experience of the past 5 years is not yet suggestive that the world has changed.

But the doomsayers may argue, even if the world hasn’t changed, we could be in for a string of very adverse share market returns – look at Japan. Surely, cash is the safe alternative, because you can’t lose your initial investment. But in real (i.e. after-inflation) terms, you can.

The chart below provides the same analysis as that above, for cash. Please note when comparing the two charts that the Y-axis is scaled on a logarithmic basis and the scale varies between the charts.

Has the investment world changed?

It’s a little difficult to see, but to be 95% confident of obtaining a positive real return on cash, the analysis suggests you need to be prepared to invest for about 42 years (compared with 21 years for shares). For 99% confidence, more than 86 years (compared with 40 years for shares)! This doesn’t sound like safer to us.

Short term capital protection is cash’s strength

So, in terms of long term after-inflation capital protection, the safety of cash is questionable.

Of course, cash returns are far less variable than shares – the range between the 5th percentile and 95th percentile at Year 86 is $3,981 for shares and only $0.84 for cash. But this hardly seems a virtue when the low, 5th percentile value for shares at Year 86 is around $17 and the high, 95th percentile value for cash is $2!

However, the reality is that most people can’t or don’t have the stomach to wait 86 years to witness the expected return superiority of shares. Large short term share losses, even if followed by compensating gains, may decimate the retirement plans of retirees or test the nerve of the most disciplined investor.

The table below, extracted from the simulations, reveals the largest wealth losses at the 5th and 1st percentile levels for both cash and shares. It highlights the power of cash to place a floor on short term wealth erosion in adverse markets:

Investment

5th Percentile

1st Percentile

 

Maximum Wealth Reduction (%):

In Year:

Maximum Wealth Reduction (%):

In Year:

Shares

28

5

50

12

Cash

5

10

9

17

 

Our tentative conclusions then are:

  • It doesn’t appear that the world has changed; and

  • Cash may be “safer” in the short term, but shares are “safer” in the long term, with respect to after-inflation capital protection.

However, as will be discussed in our next article, a wise investor is unlikely to restrict their choice to either just cash or just shares.

>> Click here to read other articles from this week's newsletter

 

Wealth Foundations (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369). The material contained in this article is for general purposes only and should not be used as a substitute for personal financial advice. This article does not take into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material. Before making a financial planning or investment decision, you should consider if it is appropriate for your circumstances. You should read and understand any relevant Product Disclosure Statements or any other associated documentation relevant to your individual situation.

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