Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
How much money can you make from investing?
Most people should be familiar with the fact that investing in stocks and shares (also known as equities) can often generate a greater return than cash. But do you have an idea as to how much money you can realistically make from investing?
One of the big problems we’ve found over the years is that less experienced investors jump to conclusions and believe they can double their money on the markets in a short period of time. They get frustrated when the returns don’t meet expectations so they give up.
In reality, investing in stocks and bonds can be very rewarding as long as you appreciate it generally takes time to build up wealth.
It involves taking on greater risks than cash in the bank, but the rewards can also be greater.
The purpose of this article is to rebase your expectations with regards to the level of potential returns by using historical examples of market performance.
We aren’t saying you will get the same returns in the future as no one knows what will happen. We’re merely pointing out past trends over different time periods and also comparing the performance of different asset classes, so you can get a sense of what’s possible from investing.
On a final note before we drill down into the numbers, we do acknowledge you can sometimes get significantly greater returns from individual stocks and potentially some funds, compared to looking at the market as a whole.
You can also make less money, or even lose money. The purpose of this article is to simply look at the market from a broad perspective.
WHAT HAVE WE LEARNED?
We’ve used two trusted sources of information: Barclays’ Equity Gilt Study and Credit Suisse’s Global Investment Returns Yearbook.
The historical performance of equities and bonds varies depending on the time frame. For example, Credit Suisse’s study finds that equities achieved 6.4% annualised real returns between 1968 and 2017. That assumes all dividends were reinvested, and the returns have been adjusted for inflation.
In contrast the annualised returns figure falls to 5.5% if you look at the performance between 1900 and 2017. It drops even further to 2.9% if you just look at the period between 2000 and 2017.
It is really important to note these figures are inflation-adjusted. Lots of articles in the media have historically talked about 7% typical returns from equities which is perhaps a bit misleading.
Many investors forget about inflation and how it eats into the real value of your money. So by adjusting for inflation these performance figures are providing a fairer indication of how much wealthier in real terms you could have been by investing.
Barclays’ study also adjusts its figures for inflation. It finds that equities achieved 5.6% annualised return in the 50 years to the end of 2017. You will notice how that is a lower figure than the comparative period analysed by Credit Suisse (6.4%). The difference can be put down to the calculation methodology. For example, Barclays obtains its results from an index containing only 30 companies.
What’s really interesting from Barclays’ study is that long-dated gilts (UK Government bonds) outperformed equities over the past 10 years (to end of 2017), achieving 4% annual gain versus 3.2% from equities.
You could argue these figures don’t make sense given investing in equities is supposed to be riskier than bonds and so the rewards should be greater. It can partially be explained by loose monetary policy and low interest rates driving demand for gilts, pushing up their prices and dragging down their yields.
If you believe that gilts are currently too expensive, one strategy might be to avoid them (or sell any you have) and wait until interest rates have risen substantially before giving them another look. However, there is always merit in having some permanent exposure to this asset class if you want a truly diversified portfolio.
On a longer-term basis, gilts achieved 4.3% annualised real return (with income reinvested) between 2000 and 2017; 3.8% between 1968 and 2017; and 1.8% between 1900 and 2017, according to Credit Suisse’s research.
If you dig into the data, you’ll see from the following table that gilts can go through bad patches. For example, they only delivered 0.8% annual real return between 1957 and 1967.
The following 10 years saw them actually lose money for investors with 3.2% real annual loss over that decade.
Bonds’ biggest threats are time, the interest rate, the issuer and the economic environment.
When investing in gilts, the issuer shouldn’t be too much of a problem; it’s unlikely that the UK is going to default anytime soon. This isn’t true of all sovereign bonds as countries such as Greece and especially Argentina do definitely have what’s termed credit risk, i.e. they might default.
More relevant for gilt investors are higher interest rates and inflation. If interest rates rise to a significant level, bonds will look less appealing than cash. In reality this is unlikely to happen in the foreseeable future as interest rates are currently 0.25% whereas the yield on a 10-year gilt is 1.5%.
More destructive to these types of investments is inflation; when it rises, it makes the payments received on the bond less valuable.
You can buy inflation-linked gilts which mitigate this phenomenon although these assets have returned the same as gilts on an annualised 10-year basis, being 4% according to Barclays’ research. This may be due to the relatively low levels of inflation during the time period.
THE MAGIC OF COMPOUND INTEREST
When investing, interest is earned on the capital either in the form of coupons for bonds or dividends for equities (although not all companies pay dividends).
If the interest is reinvested, the capital grows as does the interest which is a percentage of the initial investment. Luckily there’s a quick and easy formula to work out how quickly this can bring in decent returns.
Given the equations related to compound interest are too complicated for most people to do without a calculator, there’s a simple solution called the rule of 72. If we take the annualised rate of return it’s easy to find out how long it will take to double your money.
• Years required to double your money = 72 divided by the annual rate of return •
Using Barclays’ 10-year annualised rate of return for equities of 3.2%, it would take approximately 22 years to double your money
in real terms.
While it may appear useful to have a simple formula to work out how long it will take to double your money, equities are a volatile asset class and small differences to performance in a single year can make a big difference to your longer term returns.
According to Barclays the real return on equities in 2017 was 8.4%. If we assume this rate of return going forward, it would only take 8.6 years to double your money. However, it is unlikely that rate of return for one year will remain the same going forward as markets go up and down.
You may find a solution is to build a diversified portfolio which means investing in a variety of assets that will react differently in certain market conditions. This can be done by investing in a variety of asset classes, including bonds, property, gold and cash or by choosing varying types of companies that behave differently depending on where we are in the market cycle.
For instance, cyclical stocks such as banks and miners may do well when the economy is growing but suffer during downturns. Defensive stocks such as healthcare assets may allow investors to smooth out the downturns as they theoretically offer downside protection.
A TALE OF TWO STOCKS
To illustrate the varying fortunes of investing in the stock market, let’s look at how London Stock Exchange Group (LSE) has performed. If an investor had chosen to invest in the company five years ago, they would have made a return of 247% today as the company’s stock has been on the ascendency. Not a high paying income stock, its dividend yield is just over 1%, the bulk of the returns are made through capital appreciation.
On the other end of the scale is retailer Marks & Spencer (MKS). An investment in this stock would have reduced your invested capital by 32% over five years. The decline of physical retailers is not a new phenomenon but a persistent one. These stocks are examples of how volatile the stock market can be and why there is no such thing as a guaranteed return.
HOW HAS CASH PERFORMED?
Cash has delivered a real return of 0.3% per year over the past 20 years, or 1.2% over the past 50 years, according to Barclays’ study.
Over the past 10 years you would have incurred a 1.9% annual real loss on holding cash. If you think this sounds odd when you can get positive (albeit modest) rates of interest in ISAs and savings accounts, just remember the performance figures have been adjusted for inflation.
The allure of cash is obvious; many who witnessed two stock market collapses in a decade may understandably think that cash is the far safer option. However, stock markets often recover quickly from crashes, as evident in how 2009 was one of the greatest
buying opportunities for shares in recent memory – only a year after one of the biggest ever stock market crashes.
Cash may bring short-term comfort but history suggests this asset class will significantly lag shares and bonds over the long-term.
That said; you should always have some cash as an emergency buffer in case something unexpected happens in your life. It is also worth having some cash to hand in case markets fall and you can act on sudden price weakness by buying stakes in some great companies or funds.