This blog is written for grown-ups who know where babies come from. But it has been brought to my attention that not everyone knows where stockmarket returns come from. So let’s put that right.
2019 was another stand-out year for stockmarket returns around the world. The chart below is in $ terms so the percentages in £ sterling terms will be slightly different but you get the picture – 2019 was a great year.
Results like this will, for many people, prompt the thought that it’s all too good to be true and what goes up must go down.
It’s certainly possible that stockmarkets will crash this year. But that’s possible any year. A stockmarket crash is always coming…but that’s no reason not to play this wonderful game where the odds are stacked in your favour over the long term.
Here’s the issue: a lot of people don’t understand where stockmarket returns come from. There are always plenty of forecasters of doom on hand to tell you that the gains are not real and markets are being pumped up artificially as a result of some dark conspiracy by Central Banks / Governments / Donald Fist-Bump [delete as applicable] and will soon come crashing back down.
Sometimes you will hear this sort of thing from The Bloke in The Pub, sometimes from The Bloke on The Internet. Bizarrely, people often seem to place more weight on The Bloke on The Internet…even when he’s some unseen anonymous clown. At least you can see that The Bloke in The Pub is
full of shit unreliable: he’s been drinking and is wearing a cardigan that’s seen better days.
It’s certainly true that governments have held down interest rates and that’s lifted all asset prices but that’s no secret. If you read it on The Internet, then it’s already priced in.
People invent stories to try to make sense of the world. These after-the-fact explanations are comforting to our tiny monkey brains. The demand for
fairy tales market forecasts of the future (and explanations of what just happened) exists so people make up stories to meet it.
It’s strange but the bear case always sounds smarter. In contrast, the optimists sound a bit naive. Yet, look at what has already happened. Look how far the human race has come and how unlikely that would have seemed 50,000 years ago. Homo Sapiens nearly went extinct during the ice ages. Apparently, at one point we were down to a few thousand people clinging on to the southern tip of Africa surviving on worms and shellfish. I’m told the food in the bars and restaurants of Cape Town is much better these days.
We now live in a world of affluence unimaginable to our ancestors. The agricultural revolution happened. That was highly improbable. The only thing more unlikely than that was the industrial revolution. And then the information technology revolution…all of which means we’re living through the greatest period in human history. All insanely unlikely and impossible to predict in advance, all inevitable with hindsight.
The story of the stockmarket is the story of human progress. There is a good reason why the market always trends upwards. Yes, its two steps forward and then one step backwards. No, there are no guarantees as to what will happen in the future. But, with perspective, the progress is obviously much more forward than backwards.
If at any level (conscious or sub-conscious) you think of the stockmarket as a casino, scam or an evil tool of capitalism, you won’t play this game where the odds are stacked in your favour. That’s a form of self-sabotage. So let’s go back to basics and think about where equity returns come from.
Imagine you own shares in a company. Contrary to popular opinion, this is NOT like gambling in a casino. No, you are a part-owner of the business. You become a part-owner of all the assets (factories, warehouses, forklift trucks, productions lines, raw materials etc etc) of the business.
You get your share of all dividends paid by the company. You get a vote at shareholder meetings of the company. If the company gets sold (taken over) you get your share of the sale proceeds. When you buy a share, you have limited downside (you can’t lose more than you put in) but unlimited upside.
Thanks to technological progress, companies get better and better at making stuff each year. Competition forces them to improve. Free market capitalism means that different firms are competing with each other to best serve the customer and give them what they want. And when I say free-market capitalism, I mean regulated capitalism with a government that maintains an independent legal system, promotes competition, breaks up (or regulates) monopolies, provides a public health service and a welfare safety net.
Yes I know that sometimes people want and buy things that are bad for them. Yes I know that companies often try to
screw their customers put their prices up. That’s their job. It’s our job as customers to shop around, make mindful spending decisions and get the best value. Companies are not your friends nor your enemies. It’s just business.
There is no system other than capitalism capable of feeding 7+ billion people…let alone allowing them to thrive and get rich. History shows us that the problem with communism is that you end up eating your pet dog. Socialism (its baby brother) is not quite as bad : the dog survives but you may have to share some of its Pedigree Chum when things get tight.
Back to business. In the chart above, we are talking about total returns. There are 2 elements to the return that you get from shares (aka equities, stocks) or from investment property.
Lets start with property as that’s easier for people to imagine. So…if you own a Buy To Let flat or rental apartment, where do the returns come from?
Well firstly there is the income. This is the rent paid by the tenant. If you buy a flat for £200,000 and rent it out for £6,000 per year in rent, then you are getting a 3% rental yield.
Then secondly there is the capital gain. Let’s imagine that you put the rent up most years. This covers inflation and allows you to have the flat maintained and redecorated every now and again. If the income from the flat is going up, the market value of the flat is also likely rise over time. Yes, some years there will be property slumps as well as mini-booms. But over time the clear trend will be upwards.
So if the flat goes up in market value from the £200,000 that you originally paid to £210,000 one year later that’s an increase in capital of 5%. So rental income of 3% plus capital gain of 5% = total return of 8% per year.
Now lets move on to the stockmarket where exactly the same principles apply. There are two parts to your total return: income and capital gains.
Firstly there is the income. Companies pay dividends out of profits. Imagine a company makes total profits after tax of £100m. It might then pay one third (£33m) of this to its shareholders in dividends.
If you buy £1,000 worth of shares paying you dividends of say £30 in year one, then you are getting a 3% dividend yield. This is your dividend income that you can use to live off or to reinvest and buy more shares that will pay you more income and so on.
Then there is the capital gain. Share prices go up. Not always and not every year. But over the long run they go up a hell of a lot more than they go down.
Remember those profits not paid out as dividend? The other two thirds (£67m) is kept and reinvested in the business. For example, it might be used to fund the building of a new factory or the development of new software. This should make the company more valuable and that drives increases in the share price and in the company’s market value. This is why the stockmarket always trends upwards over the long term.
If your shares go up in market value from the £1,000 you paid to £1,060 one year later, that’s an increase of 6%. So rental income of 3% plus capital gain of 6% = total return of 9% per year.
One of the most fundamental choices an investor can make is their asset allocation: your chosen mix between “engine assets” (e.g shares, property) and “shock absorber assets” (e.g cash, bonds). Engine assets give you a rollercoaster ride but, over the long term, the odds are MASSIVELY stacked in your favour.
Remember: rollercoaster rides are very safe as long as you stay strapped in. Just don’t get out halfway through the ride. Did I mention that you should never be a panicked or forced seller of risk assets in a downturn? Yes, I think I did.
Investing is simple enough for anyone to do it. I write this blog in the hope that people (who might otherwise be intimidated by jargon) gather up the courage to overcome their fears and take action.
It’s totally normal to feel fear. Throughout evolutionary history, fear has been the ultimate survival mechanism. But most people are afraid of the wrong stuff.
People are way, WAY more scared of the risk of a 25% drop in the stock market…than losing small amounts every day due to inflation, fees, & poor asset allocation, which add up to far more over a lifetime This is one of the most costly mistakes in life