How you can get a real return without taking big risks
Phil Oakley Jan 18, 2013
What’s the aim of investing?
The simple answer is: “to make money”. But it’s not quite that straightforward.
If you want to be truly better off for investing, you have to find a way to grow your money faster than the rate of inflation. It’s only by getting a ‘real’ (after-inflation) return, that you are able to buy more things with your money than you could before.
I’d go even further: you also want to do this without taking big risks with your money.
So that’s the secret to investment success: get a real return, without taking big risks.
It sounds easy. But in fact, I don’t think it’s ever been harder than it is today…
Investing in a world of low interest rates is hard
There’s a lot of debate over what the true rate of inflation is. Many people distrust official government measures, believing they are designed to understate inflation.
We wouldn’t necessarily disagree with that view. But even if you use the official statistics, inflation is a tough hurdle to beat for investors. Last month, prices in the UK were rising at an annual rate of 3.1%, as measured by the retail prices index (RPI).
Now look around the investment world. Where can you get returns of more than 3.1%? And where can you get them without taking lots of risk?
Most cash accounts yield less than inflation (especially if you pay tax). The ten-year UK government bond (gilt) has a redemption yield of just over 2% - in other words, if you hold it until it matures, you’ll make an annual return well below inflation.
UK government index-linked bonds have some protection from inflation. But currently they offer a negative real yield of 0.75% (based on the 2.5% 2024 bond). Gold is fine as insurance against central bank money printing, but ultimately it yields nothing. And forecasting the future price of any commodity is nigh-on impossible.
So if you want a real return you’re going to have to look beyond these assets. By spreading your investments across different asset classes, you can spread your risks, and hopefully reduce your chances of losing lots of money if some markets fall.
The theory behind diversification is that not everything will go up or down at the same time. It’s not always true - during the 2008 financial crisis most assets fell in value – but it’s usually good advice.
These assets have reasonable yields – but I’d avoid them
Lots of money has been pouring into high-yield (or ‘junk’) bonds lately. Right now, you can buy European and US high-yield bond exchange-traded funds (ETFs) with income yields of 6.2% and 7.3% (their respective yields to maturity are 5.0% and 5.8%). But whether these yields are high enough to compensate you for the risk of some of the companies behind the bonds going bust is debatable.
Average rental yields on UK residential properties are currently 5.4%, according to LSL. On the face of it that looks reasonable. But if you take maintenance costs, agency fees, voids and mortgage costs into account, we doubt the income return is above inflation. Given that we see UK houses as still being expensive, there’s still a significant risk to your capital too.
If you are really adventurous, you could bet on assets like Greek government bonds continuing their stellar run. Ten-year Greek debt has a current redemption yield of 11.7%. But this still looks like a risky punt to me, rather than sensible diversification.
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So where should you put your money?
Last week, I wrote about the bond bubble bursting. Interest rates can’t stay low forever, despite the best efforts of the central banks. The Bank of England might be able to keep printing money to buy the government’s debt and suppress bond yields. But whether it can do this without trashing the value of the pound is another matter.
That said, this situation could continue for a while yet. If so, then investment-grade corporate bonds may prove a reasonable diversification option in 2013. For example, the Markit IBoxx £ Corporate Bond ex-Financials ETF (LSE: ISXF) offers a redemption yield of around 3.7%. That’s a very small real income return - and it will not grow. So it’s not very tempting, but cautious investors might consider it.
That just leaves equities, which most people seem to be bullish on just now. I’m always wary when a growing consensus in the markets favours one asset class, but that doesn’t mean it’s always wrong.
Shares are risky investments in real assets (companies) and can be a decent hedge against inflation (at least in the early stages), particularly if you invest in companies that are able to raise prices. And even although most shares aren’t dirt cheap right now, many of the dividend yields on offer beat inflation, and also have the potential to grow.
So as part of a diversified portfolio, I’d say that stocks are the ‘least-worst’ option for investors who are trying to grow their money. But which market should you invest in?
Which markets offer the best value?
There are lots of ways to value stock markets. But I’ve taken a relatively simple approach, and looked at the 2013 forecast price/earnings ratios and dividend yields for some of the world’s main stock markets. I’ve also calculated the forecast dividend cover as a check on the safety of projected dividend payments. The details are in the table below.
|Index||Forecast p/e||Earnings yield||Dividend yield||Dividend cover|
|S&P 500 (USA)
|FTSE-All Share (UK)
|CAC 40 (France)
|Ibex 35 (Spain)
|FTSE MIB (Italy)
|Hang Seng (Hong-Kong)
|ASX 200 (Australia)
On this basis, Europe looks reasonable value: even staunch pessimist Albert Edwards of Societe Generale thinks European shares are cheap. The UK, France and Italy look fairly cheap with decent dividends and reasonable dividend cover. The caveat here is that you are assuming that current profits and dividends are sustainable, which is not a foregone conclusion given the fragile economic state of the world.
If you’re looking to build a simple portfolio, use cheap index funds or ETFs to limit the risk involved in buying individual shares. Make sure you read the fund factsheet to see how it is made up. Big dividends are all well and good but if they are coming from just a few stocks (I’m thinking of indices like the FTSE 100 here) you might want to find another, more balanced market to invest in.
• This article is taken from the free investment email Money Morning.
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