NZ Herald 11 September 2010

AMaybe we are. Investment is full of “maybe”s. And I must say that recent market trends have made me less comfortable suggesting people invest in shares if they have ten years before spending the money.

Let’s start with three aspects of this issue:

• Share performance. In our first graph, every point on the line is the average annual return on unhedged overseas shares for the ten years ending at that point. For example, in the ten years up to March 1980, the average annual return was about 8 per cent.

The ten-year averages have been negative recently. That’s the result of not one but two big share plunges — the bursting of the tech bubble at the turn of the century and the global financial crisis.

However, the graph also shows how rare negative ten-year returns are. And the second graph shows it hasn’t happened at all in New Zealand in recent decades.

• Comparing shares and bonds. While shares have had a less-than-marvellous time, bonds have had a ball in the last decade or two. That’s because interest rates have fallen a long way — partly the result of lower inflation. And when interest rates fall, bonds that have been around a while at the old higher rates grow in value. That translates into strong one-off capital gains on bonds.

When those gains are added to relatively high interest, bonds have outperformed shares fairly often in single years. And over the longer term, the performance of international shares and bonds has been about even — although in New Zealand shares have still significantly outperformed local bonds. See the third and fourth graphs.

Is the strong bond and weak share performance likely to continue? Well, bond interest rates haven’t got that much further to fall. They can’t go below zero, or everyone would keep their money under the mattress. That eliminates further big gains on bonds. That, accompanied by the lower interest rates, means total bond returns are likely to be lower.

What about shares? The Economist article you quote includes the following: “It is tempting to assume that because equities (otherwise known as shares) have performed so badly over the past decade, they must be a sure thing to perform well over the next ten years. But that argument failed in Japan.”

True, but the Japanese market is hardly typical. While share returns are impossible to predict, studies show that after a share market has performed badly it’s more likely than usual to perform well.

• Logic. This suggests shareholders will usually receive higher returns than bondholders. If a company gets into financial trouble, bondholders get their money back first and shareholders are left with whatever remains. Shareholders take higher risk, so they need more reward or nobody would buy shares.

So what happens when returns on shares are lower than bonds? Some shareholders view shares as less desirable, so they sell into a market with few buyers. That drives down share prices, until the point that people realise shares are bargains, so they start buying again.

If you buy a share cheaply, the dividends are higher relative to your purchase price. And when you finally sell, you’re more likely to sell at a gain. Your total return is higher than it would otherwise be — and probably higher than the return on bonds. We’re back to business as usual.

While various commentators — including Paul Woolley as quoted by Brent Sheather — reckon the efficient markets theory has been “discredited”, that depends on how you define market efficiency.

I’m confident that markets are efficient enough that if share returns slip below bonds, the mechanism I’ve just described will bring things back into line.

Sometimes, though — as you say — that takes a really long time, particularly when psychological issues sway the crowd. And we never know, except in hindsight, where we are in a cycle. That’s why I suggest people don’t try to time their entry into the share market. It’s too easy to get it wrong.

A much lower-risk strategy is to drip-feed money in gradually — as happens to employees in KiwiSaver. You sometimes buy cheaply and sometimes expensively. And whenever you have a ten-year horizon for staying in shares, you will have already owned most of your shares for several years — so their total holding period will be considerably longer than ten years.

Where does all this leave us? Should I continue to suggest shares for those with ten or more years before they spend the money, even though bonds sometimes bring in higher returns?

There’s a key factor we haven’t considered yet — inflation. We’ve become used to low inflation, but some are predicting it will rise, locally or internationally. And if inflation gets up a head of steam, we could see a similar situation to the late 1960s to early 1980s, when interest on bank term deposits was well below inflation. The buying power of savings went backwards. Bonds, with somewhat higher interest, wouldn’t have done much better.

Share returns, on the other hand, tend to increase with inflation. So, while they are more volatile than bonds and term deposits, when it comes to inflation — and the buying power of money — diversified shares are less risky.

Here, then, is what each asset type offers you over ten to twelve years:

• Diversified shares — highly likely return of your money; possibility of high returns; good protection against inflation.
• Bonds — certainty of return if you hold to maturity (and the companies don’t default); higher return than term deposits; no natural protection against inflation.
• Short-term (less than one year) bank term deposits — certainty of return; lower return than bonds; some protection from inflation because interest rates are likely to rise with each rolled-over deposit.

Over all, I still lean towards shares for the long term — although perhaps I should start saying “for at least ten to twelve years” rather than just ten.

AThanks for this. There’s never any harm in checking out the free stuff first.

AGood advice — although the account that I suggested be in the woman’s name only was for fairly small amounts.

Generally, joint accounts are best to the extent the two people are merging their finances. These days, some couples keep some of their money separate, which won’t usually be a problem if one dies suddenly as the other will have access to their own account.

On utilities, if people live together, chances are that utility money will be pooled, and the account should clearly be a joint one.

I also like your comments about enduring powers of attorney. Basically, you name who will make decisions about your personal care and your finances — it can be two different people — if you become incapacitated. It can happen to anyone at any time.