This article is part of Morningstar.co.uk's Equity Investing Week.
It is true that if someone puts their life savings into the shares of one or two companies in the expectation of a rapid return they are taking a big risk. If they are lucky they could make a substantial gain but they could equally make large losses.
But there are two main ways in which investment in shares can be made less risky. One is to diversify from one or two firms to a mixed basket of different types of shares. The other is to extend the duration of the investment to a longer time span.
The longer an investor's time horizon the safer it is to invest in shares. For long term investment it is actually safer to invest in shares than in bonds or cash.
The Evidence
One definitive study of this phenomenon is by Jeremy Siegel, a professor of finance at the University of Pennsylvania, in Stocks for the Long Run (McGraw-Hill 2002). From a study of American stockmarket returns from 1802-2001 he shows that shares beat bonds and bills (short term government debt) 80% of the time with a 10-year horizon, 90% of the time with a 20-year horizon and almost all the time with a 30-year horizon.
Historically this has meant that even if someone has started to invest in shares at the worst time possible (2007, for example, could certainly be interpreted as a bad time to plough cash into the stock market) they have generally made good returns in the long term. Indeed Professor Siegel starts his book with a discussion of an article published in the summer of 1929--just before the Wall Street crash--which argued for regular stockmarket investment. The article was subsequently ridiculed as it was published just before a three-year fall in the market which led to a cumulative decline of 89%. But Professor Siegel estimates that even taking this decline into account an investor who had invested in shares regularly for 30 years from 1929 would have made an average annual return of 13%.
Although Professor Siegel's study concentrates on North America, the British market has behaved in a similar way. Over the long term shares have easily outperformed other asset classes.
Perhaps the most definitive study of long-term investment trends in relation to the British market is Triumph of the Optimists (Princeton University Press, 2002). The title itself is based on the fact that shares have outperformed other assets in the long term. According to this study an investment of £1 in shares in 1900 would have grown to £16,160 in nominal terms by the end of December 2000. In contrast the figure for long-term bonds was just £203 and for short term Treasury bills only £149.
Of course once inflation is taken into account the increases are not quite so dramatic. Once the 55-fold increase in prices over the century is incorporated into the calculations the return on shares would have been 291 times in real terms, 3.7 on bonds and 2.7 on bills.
It also needs to be taken into consideration that few investors are likely to invest in shares for an entire century.
The Risk of Inflation
One advantage of shares over bonds is that they tend to perform much better in periods of high inflation. Whereas inflation tends to quickly erode the capital value of bonds, the stockmarket generally at least keeps up with rising prices. In other words one way in which shares are less risky than bonds is their relative immunity to the risk of inflation.
Another factor that can affect relative returns is taxation. For instance, if a government decided to impose a punitive tax on share dividends it would clearly hit returns. But, historically, companies have often found ways round this problem such as distributing income by buying back their own shares.
As with all forms of investment the past is not necessarily a guide to the future. Investors know only too well the damage caused to equity valuations by financial crisis and resultant economic recession. Stock markets have largely recovered to levels previously seen in 2007 but returns in decades to come may not be nearly as great as during the great bull market of 1982-99. However, historically there is no doubt that over the long term shares have proved both less risky and more lucrative than the other main forms of investment.
