Which way now?
Ian Cowie makes the case for investments versus cash
Higher interest rates on bank and building society deposits – plus National Savings & Investments’ market-leading 6.2% Guaranteed Growth Bond – mean savers and investors need to think carefully about the best deal for each of our individual needs. The devil is in the detail and often bonds or deposits described as “risk-free” can disappoint on the downside.
For example, the new NS&I offer has hit the headlines with its highest return since 2008 on one-year fixed-rate bonds up to £1 million. But gross returns are subject to income tax at each saver’s marginal or top rate and these bonds cannot be put into tax-free individual savings accounts (ISAs).
Another potential problem affecting a wider range of savings and investments – including bonds or deposits and shares – is that inflation can erode the real value or purchasing power of money over time. For example, the official Consumer Prices Index (CPI) increased 6.8% in the year to July – the most recent figure from the Office for National Statistics (ONS). If inflation remained at that level, the real value of money would be halved in just over ten years.
That’s much less time than most people can expect to spend in retirement these days. Worse still, the ONS also reports that the Retail Prices Index (RPI) measurement of inflation is rising by 9% per annum. If that rate is sustained, it would halve the purchasing power of money in just eight years.
The good news is that many shares including investment companies have long histories of raising dividends, or the income paid to investors, and growing their capital values or share prices. However, unlike bonds and deposits, shares and investment companies make no guarantees about capital or income and both can fall without warning.
“The official Consumer Prices Index (CPI) increased 6.8% in the year to July – the most recent figure from the Office for National Statistics (ONS). If inflation remained at that level, the real value of money would be halved in just over ten years.”
Conversely, many have risen over the medium to long-term in the past. For example, the annually updated Barclays Equity Gilt Study analyses total returns from bonds, deposits and a wide range of shares reflecting the changing composition of the London Stock Exchange (LSE) since 1899.
Its 2023 edition reported that over any period of five consecutive years during that period of more than a century, shares delivered higher real returns – that is, after the illusory uplift of inflation was stripped out – than bonds 72% of the time and beat deposits 76% of the time. So that’s an historical probability of shares doing best in about three in four investment periods of five years in a row.
“Where the investment was held for ten consecutive years, the chances of shares beating bonds increased to 77% and the probability of shares doing better than deposits soared to 91%.”
Where the investment was held for ten consecutive years, the chances of shares beating bonds increased to 77% and the probability of shares doing better than deposits soared to 91%. It is important to remember that the past is not necessarily a guide to the future but it does provide a factual basis upon which to consider alternative saving and investment strategies.
More positively and specifically, investment companies can diminish the risk inherent in stock markets by diversification and share the cost of professional fund management. Unlike other forms of pooled fund, investment companies can retain up to 15% of returns in good years to sustain dividend distributions – or income payments to shareholders – in bad years.
This unique feature of investment companies has enabled 20 of them to increase dividends every year, without fail, for 20 years or more. No fewer than nine of them have given their shareholders annual ‘pay rises’ for 50 consecutive years or more. No wonder they are known as ‘dividend heroes’.
Similarly, 28 other investment companies can show at least ten consecutive years’ dividend increases, although they have yet to deliver annual pay rises without fail for two decades. They are known as ‘the next generation of dividend heroes’.
So, while bonds or deposits that guarantee the return of savers’ capital and promise to pay income might be best in nominal terms over the short term, their real value or purchasing power may be reduced by inflation and/or taxation. However, shares in general and investment companies in particular have a long history of delivering higher returns over the medium to long-term, or periods of more than five consecutive years, and can be sheltered from tax in an ISA.
“Shares in general and investment companies in particular have a long history of delivering higher returns over the medium to long-term, or periods of more than five consecutive years, and can be sheltered from tax in an ISA.”
The price stock market investors pay in pursuit of those higher rewards is the higher risk of volatility, or the tendency for valuations to fluctuate unpredictably. The price bondholders and bank or building society savers pay for their guaranteed nominal rewards is the risk of lower real returns or reduced purchasing power.
That’s why holding cash in savings accounts can, paradoxically, be described as “reckless prudence”, a phrase that was familiar in the 1970s and 1980s when many nominal ‘risk free' returns failed to preserve the real value of money. By contrast, many investment trusts have a long history of sustaining rising income over long periods. The dividend heroes and the next generation of dividend heroes should be considered carefully by investors who aim to preserve the purchasing power of our capital and income over the medium to long term.
