Equities – investment friend or foe?

Over the last few months stockmarkets around the world have suffered increased volatility, with the UK FTSE All Share falling over 10% from its high in 2007.

It is not surprising, therefore, to hear such comments as ‘Markets are uncertain’ and journalists and other ‘experts’ questioning whether capitalism as we know it will cease. Markets are driven by news and such news is random. Stock markets are always uncertain, otherwise there wouldn’t be a return premium for owning equities and we would all own government bonds or cash. In addition, while seeing the value of one’s capital fall and rise wildly can be emotionally uncomfortable in the short term, inflation is arguably the greater threat to long-term financial security and freedom of choice.

Short term forecasting of what will happen to different asset classes is a fool’s errand and is of no benefit to the smart investor. Whenever annual investment returns from equities depart materially from the long term norm this is not usually due to the economics of investing - the earnings growth and dividend yield of companies. Earnings growth has been positive in every moving decade since the 1930s and dividends are always a bonus, not a given. Stockmarket returns are volatile because of the emotions of investors and their willingness to pay a higher or lower multiple for earnings from companies. The price/earnings ratio, as it is known, reflects the swings in investor emotions ranging from greed (high P/Es) to hope (moderate P/Es) to fear (very low P/Es).

Because the bulk of returns from stock markets are based on earnings and dividends, the market has a positive sloping return expectation and in broad terms there is a 3 out of 4 chance of returns being positive in any given year. Therefore, forecasting long-term returns, rather than short term investor sentiment, is actually a much more achievable task. Benjamin Graham, the famous American investor once said “in the short run the stock market is a voting machine... (but) in the long run it is a weighing machine.”


Investment return and speculative returns

John Maynard-Keynes, the famous economist, divided stock market returns into
1) Investment Return – being the dividend yield on equities plus the subsequent earnings growth; and
2) Speculative Return, being the impact of changing P/E ratios on equity prices. Putting the two together gives us
3) Total Return on equities.

So if we assume a dividend yield of 3% and earnings growth of 4.5% we get an expected return of 7.5% for the next 10 years. Let’s assume, say, that the P/E rises from 11 to 15, representing an increase of 36%. Spread over a decade it would add over 3.5% per annum to the return. If, say, the P/E fell to 10 then the return over the following decade would be just under 0.90% per annum less.

Over the last 100 years the average total return on equities of 10.1% was almost the same as investment returns from dividends and earnings growth of 9.90X%. All that speculation only generated an additional 0.20% annual return. But speculation does create many short term variations such as in the tech boom of the late 1990s or the melt down of the early 1970s.


Future return expectations

So how can we use this approach to predict future returns from equities over, say, the next 10 years or more? Nominal earnings growth has historically averaged about 7% per annum depending what time period and market one looks at. If we assume it will run parallel to the growth rate of the economy then over the next 10 years there is no reason not to assume between 4-5% as earnings growth, so I’ll use 4.5% per annum.

Dividends are slightly different and from a high of 6.80% in the late 1970s, when they contributed almost 70%% to the total return, they fell to 2.2%% by the start of this decade, a reduction of almost 70%. The yield on the UK All Share Index is now about 3.5%, as a result of the fall in share values and rising profits, so when added to our growth rate this represents well over 40% of the expected return.

The P/E ratio rose throughout the 1980s and 1990s from a low of 10 (fear) to a high of 25 (greed). There then followed a reduction to the current ratio of 11. Looking forward, which is always the tricky part, it is highly likely that the P/E will ease downward rather than surge upward, so my best guess is that we will see the P/E ratio fall from the current 11 to, say, 10, which is below the historic long term average of 13. This would mean the P/E ratio would fall 9%, equivalent to a reduction in the expected investment return over 10 years of 0.90% per annum. If you have your own ideas on the direction of P/Es then do your own calculations to determine your expected future return using the same formula.

I think it is safe to assume that over the next decade or so we are unlikely to experience the double digit returns of the 1980s and 1990s. A return in the range of 6-8% per annum seems more reasonable but it will probably come with more volatility. So the only certainty about the future is that it is uncertain. There are returns from capitalism that are there for the taking but one needs to focus on the long term trends, not the short term noise. Or put another way, don’t measure the distance between your home and your office with a 6 inch ruler!

Written by Jason Butler
Jason Butler APFS IMC CFP is a Chartered Financial Planner and Investment Manager. He is the founder and senior partner of Bloomsbury Financial Planning based in The City and has 20 years’ experience advising successful families on managing their wealth.

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Hiding Investments from Mr Taxman

Almost every time we earn or spend money, the taxman is waiting to take his slice. Unfortunately there is no exemption for your savings.

But there are legal ways to shelter your nest-egg from the Inland Revenue’s grasp by taking advantage of Individual Savings Accounts (ISAs). There is also a whole host of other options that will allow you to minimise the amount of tax you pay each year and, therefore, make the most of your savings.


Individual Savings Accounts
The Individual Savings Account (ISA) is simply a tax-free umbrella that enables you to legally shelter cash, shares and insurance from income tax and capital gains tax. The scheme was introduced by the government in April 1999 to replace the previous tax free savings vehicles – Peps and Tessas.

Unfortunately, by replacing the old regime, the government cut down on the tax breaks available to individual savers. Under the old rules investors could save up to £9,000 a year in Peps and £9,000 over five years in Tessas. Now, under ISAs, savers are limited to £7,000 a year.

The government has also decided to cut back the tax benefits even further by removing the 10% tax credit on dividends from 5 April 2004. But the tax shelter is still worth having, providing you invest for the long term.

There are three types of ISA – cash, insurance and equity ISAs. A cash ISA can be a simple deposit account or a cash unit trust while an insurance ISA can be used to shelter investment bonds, such as with profit bonds, issued by insurance companies. Equity ISAs cover a wide variety of stock market investments, including shares, funds and investment trusts.

Under the government’s rules you can shelter up to £7,000 of savings from tax every year under the ISA umbrella. You can apportion this allowance by either putting the whole amount in an equity ISA (known as a maxi-ISA) or split it between the three types, with a maximum of £3,000 in cash, £1,000 in insurance and £3,000 in the equity element. This is called a mini-ISA.

Once you have decided how to split your allowance, you cannot switch it later. You cannot, for example, move money from a cash ISA into the equity ISA, although you can, of course, switch the underlying investments you hold. You can, for example, switch from investing in Marks & Spencer shares to HSBC shares.

It is also important to remember that if you take out a maxi-ISA you can only have one plan manager a year. That means you cannot split your £7,000 allowance between one investment fund and another. There are, however, ways around this. You can, for example, buy funds through a fund supermarket where the supermarket acts as your plan manager and offers a wide range of funds to you.

Having one plan manager is not a problem for investors who want to shelter their shares as stockbrokers will buy any shares you instruct them to. There is also less of a problem for mini-ISA investors as the government allows you to put the cash, insurance and equity elements with different plan managers.

You should also remember that these allowances work on a ‘use it or lose it’ basis. Basically that means if you don’t use up your entire allowance by April 5th each year you will lose the part you haven’t used. It also makes sense to try to avoid taking any money out of your ISA as the government will not let you replace it at a later date.



Individual allowances
Once you have made the most of your ISA allowance you will have to pay tax on the remainder of your investments. You need to do this every year by declaring any income you have earned and capital gains you have made on your Self Assessment form.

But there are other ways you can cut down on the amount of tax you pay. One easy way to do this is to make the most of your personal allowance.

Every taxpayer gets a personal allowance, which enables us to earn a few thousand pounds of income each year without paying tax. If your spouse does not have an income that exceeds the personal allowance you can put some of your investments in their name to minimise tax.

You can use a similar principle if one of you pays basic rate tax and the other pays higher rate tax. Simply switch some of your investments into your partner’s name so you pay higher rate tax on a smaller sum.



Minimising Capital Gains Tax
Capital Gains Tax (CGT) is the scourge of all investors. Basically, every time you sell an asset for a profit, you make a capital gain which is taxed at 40%, although this rate falls the longer you hold the investment.

Luckily everyone has an individual CGT allowance and if you have built up a big portfolio over a number of years it is sensible to make the most of this allowance every year. If, for example, some of the shares you have been holding have quadrupled in value, it might make sense to sell a portion of them each year to use up your CGT allowance.

You can also use your spouse’s allowance so if you have a big tax liability and they don’t it is worth considering switching some assets between you. Remember that if you have made a loss in any one year, you can carry this forward to future years to set against any gains.

If you do find you are paying tax on investment income or capital gains it is probably worth employing an accountant. It might cost you a few hundred pounds but if they can rearrange your investments to minimise tax, it is money well spent.

Vinyl records investment

Hold on to your old records!

Old vinyl records are rapidly emerging as a high yielding alternative investment, it has been reported.

According to Stephen Maycock, a specialist in rock and roll memorabilia affiliated to Bonhams auction house, during the "past few years some records have soared tenfold in value, but when first released they could have been picked up for pennies".

Among the records which command high prices are early or rare releases from British rock giants such as The Rolling Stones, The Who, Pink Floyd, The Smiths and The Beatles, whose seven inch single recorded as The Quarrymen 'That'll be the Day' can fetch up to £100,000.

Also commanding high prices are soul singles, such as a first pressing of Frank Wilson's 'Do I Love You?', which was last sold for £15,000.

Mr Maycock told the Telegraph: "The Beatles are the giants for collectors as they hold universal appeal, but there are still plenty more which can prove to be great investments."

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Savers urged to take out Isas amid falling share prices

Consumers considering investing in an individual savings account (Isa) should act now, it has been claimed.

According to Anna Bowes of advisers AWD Chase de Vere, the downturn in financial markets makes this an ideal time to commit funds to an ISA.

This is despite the fact that the value of the shares may dip in the short-term could mean picking them up even cheaper.

However, Ms Bowes, said by watching and waiting for too long in the hope of securing a bargain, consumers risk missing out on good deals altogether.

She told the Observer: "If you hold out too long, you not only risk losing your Isa allowance for this tax year but could end up investing when prices are higher."

Her sentiments were echoed by Karen Ritchie, independent financial adviser at Financial Planning for Women, who urged investors to take a long-term perspective over their investment.

Ms Ritchie said: "Shares are for the long term, which in my view is seven to ten years, so you have time to ride out the volatility."

Source: London Stock Exchange website