The surest way to beat flat markets

“To assume that savers can confidently expect large wealth increases from investing over the long term in the stock market – in essence, that the investment conditions of the 1990s will return – is delusional.”

So say Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School. The best that we equity investors can hope for over the next 20-30 years is a real return of 3%-3.5%, argue the authors of the Credit Suisse Global Investment Returns Sourcebook 2013. And that’s the good news… the return from bonds or cash are likely to be far worse.

In a moment, I’ll show you an investment class that has consistently given you a far better return. And you had better give it serious consideration. Because these guys reckon we are living in a state of denial… and that a nasty day of reckoning lies ahead.

Where’s your pension coming from?

Investors remember recent history best. Since 1980 the real return from both global bonds and equities has exceeded 6%. But it’s hard to argue that this is sustainable. Given the low yields for bonds today, it might even be mathematically impossible. Yet public authorities assume that the good times are still with us.

“The deficits of funded pension plans pale into insignificance against unfunded pension liabilities”, says the report, “which have ballooned as interest rates have fallen. In the USA, the 75-year unfunded social security liability is $8.6 trillion. In the UK, unfunded public sector pension liabilities are at least £1 trillion, while unfunded state pension liabilities total at least £4.3 trillion. The increased liabilities can be met only by raising taxes, by increasing the pension age, or by cutting benefits.”

“These are harsh choices”. Quite so. But they’re all we’re left with. So the sooner we face up to reality, the better. It is pathetic to see the extent to which those who should be making “harsh choices” hide behind idiotic optimism.

“Pension plans are too optimistic”, the report continues, “especially in the USA. While the average expected return on plan assets at S&P 500 companies has fallen from 9.1% a decade ago, it still stands at 7.6%. For the UK, the implied real equity return (that is being assumed in asset/liability calculations) is greatly above the level we deem plausible.”

The government is deluded

The Financial Services Authority (FSA) “currently stipulates projections of 5%, 7%, and 9% before costs for a notional product two-thirds invested in equities, and one third in fixed income. After analysis of Yearbook data and other evidence, the FSA has reduced the assumed returns that can be used from 2014 onward to 2%, 5%, and 7%.”

“The middle, or most likely, rate of 5% is closer to what we would regard as realistic”, says the report, but given that the long-term government bond yield is 3%, the FSA is still implicitly assuming the historic 6% return from equities, rather than the 3%-3.5% that the academics deem more likely.

And if you think this is a dereliction of duty, “the UK’s Department for Work and Pensions calculates the prospective wealth of tomorrow’s pensioners using an assumed return that exceeds the most optimistic projection that the FSA now permits”.

You get the picture. We live in a world in which those responsible for our comfortable retirement have their heads firmly buried in the sand. We cannot rely upon them. So we had better take matters into our own hands. This is where the good news comes in.

Every problem has a solution

If you are a long-term investor, you should be investing in shares. Not bonds. And certainly not in cash. Most of all you should be investing in small companies.

In the two countries where long-term numbers are available, the returns from investing in small companies have trounced the market as a whole. In the USA, where the figures go back to 1926, returns from the very smallest ‘micro-cap’ companies have run at an astonishing 12.6% per year. The returns from the slightly larger ‘small caps’ have been 12.1%. And the annual return from large caps has been 9.6%.

In the UK stock market, where the data goes back to 1955, the respective numbers are 18.1%, 15.3% and 12.4%.

At this rate, your £1 invested in UK micro-caps in 1955 is today worth £15,927, £1 invested in UK small-caps is worth £3,725, but £1 invested in the shares of big companies is worth just £885. The difference is massive.

So, there you have it – the only way to beat flat investment returns is to ‘think small’.

• This article is taken from Tom Bulford’s free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

Information in Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd.

  • 4caster

    The figures here don’t make sense. You quote academics as saying that the annual return on equities from 2014 will be 3% to 3.5%. You prefer that to long term government bonds yielding 3%. Another 0% to 0.5% is a very poor return for taking the extra risk in holding equities.
    Or are your academics ignoring the dividend yield on the equities? If so, that is an extraordinary omission which completely changes the equation.
    Then in the penultimate paragraph you contrast the value of £1 invested in 1955 in big cap shares, now worth just £885, against micro-caps worth £15,927. Again, have you taken into account the dividends, which are likely to have been greater on the big cap shares? And how many companies have collapsed?: a much greater proportion of micro-caps, I would suggest.

  • Engineer

    My experience with small caps has been very bad. I repeat the question above. Has the attrition rate of small and minute caps been factored in?

  • Buffoon

    MW is steadily losing its audience from articles like this. TB is another punter out there, with nothing to offer besides an agenda for his own penny shares newsletter.

    Nothing to see here floks, move on.

  • John

    Had a few disasters with small caps myself. Now, I prefer to dripfeed into a selection of small companies investment trusts. BRSC, DNDL and AAS will do for me.

  • John

    Had a few disasters with small caps myself. Now, I prefer to dripfeed into a selection of small companies investment trusts. BRSC, DNDL and AAS will do for me.

  • clive chafer

    I agree with the comments above. I invested in Winnifrith’s Plus Markets fund which has roughly tenthed its value in the past couple of years! Perhaps that is an extreme example but it was certainly invested in the sort of microcaps that TB says are the most successful way of investing. You can have some big winners but also some very big losers/bust companies.