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Shares or cash? Look to the long term - Eureka Report article

Shares or cash? Look to the long term

By Scott Francis
July 13, 2009

PORTFOLIO POINT: Historically, the Australian share investments have had a premium of better than 6% over a simple investment in a cash account.

Stockmarket investors have been bruised and battered in the past two financial years - a period of significantly negative returns brought about by the global financial crisis and the subsequent world recession.

So it's reasonable to ask: why continue to invest in shares?

That means deciding whether the expected return from investing in shares will be higher than the return from a risk-free cash account. And to understand whether you are getting a fair return for the risks you take, you must always take into account what is known as the market risk premium.

Don't be over-awed by this relatively simple concept: the market risk premium is the rate of return an investor receives above a cash return. For example, over a period of time the average return from shares might be 12% a year and the average return from a cash 6%, making the market risk premium 6% (12% - 6%).

Long-term returns

A review of Australian stockmarket returns between 1958 and 2005, (see A Re-Examination of the Historical Equity Risk Premium in Australia) by academics Tim Brailsford, John Handley and Kirshnan Maheswaran, found that the market returned a 6.8% premium, even though the period included:

  • A number of recessions.
  • The recession of the early 1970s.
  • The 1987 stockmarket crash.
  • The Asian economic crisis.

The actual return from investing in shares over this period was 14.5% a year.

The authors reviewed data going back to 1883 but, to get the fairest possible result, 1958 was used as a starting point because the authors considered it the start of the period of reliable data in the Australian environment. (For the period 1883 to 2005, they found the average return from shares was 11.8% a year, with an equity risk premium of 6.6%.)

Separately, researchers working for the leading brokerage Credit Suisse discovered a number of key factors:

  • Over the long run (1900 to end 2008) shares have provided an investment return (combined result from all global stockmarkets) of 4.2% a year higher than investing in cash.
  • They argue that going forward they expect the return from shares to be about 3.5% a year higher than the returns from cash investments.
  • In Australia, the return has been 6.5% a year greater for investing in shares rather than cash over the same period (1900 to end 2008).
  • Their analysis confirms that higher returns have been achieved from investing in value and small company shares.
  • They emphasise that shares are a volatile asset class, although they don't provide as much effort into trying to quantify this volatility.
  • They studied the performance from shares after really good and really bad years. There did not seem to be any extra return following really good or really bad years.
  • Dividends (the income from investing in shares) in Australia between 1900 and end 2008 has grown at the rate of 5.6% a year, higher that the rate of inflation over the period of 4.5% a year.

Never underestimate fully franked dividend returns

For many investors, dividends (the income component of investing in shares) form a key component of their portfolios. In Australia, the Credit Suisse study found that dividends in Australia between 1900 and 2008 have grown at the rate of 5.6% a year, higher that the rate of inflation over the period of 4.5% a year.

This is key result. Shares are often described a "hedge against inflation", and it can be seen that the income from shares has, over time, outpaced inflation by a little more than 1% a year. Of course, this outpacing has not be in a straight line, with periods such as the current one and the early 1990s seeing share dividends fall in value over shorter term periods.

Tax might be a dry subject, but it is all too often underestimated in calculating investment returns. For example, very few managed funds report after-tax returns for investments when it would be very easy for them to do so.

So when looking at these much-publicised long-run returns from the stockmarket versus cash, it is worth keeping in mind that a cash investment is fully taxable, while shares include the benefit of some tax credits in the form of franking (imputation) credits).

That said, shares may also be exposed to capital gains tax, so a very active share trader may end up paying tax on realised gains, which will reduce their after-tax returns.

Investor behaviour

It is worth making one final comment: it does seem that many investors don't capture the reasonable long-run rewards from investing in stockmarkets. The evidence, such as the annual studies on US investors by Dalbar Inc (see Dalbar Study of Average Small Investor Behavior), suggest that many investors tend to sell shares when markets have fallen in value and the economic news is scary, and get enthusiastic about investing in shares when markets have risen again and shares seem "less risky".

Indeed, the Dalbar studies over 20-year periods suggest that even in times when stockmarket returns have averaged 12% a year, the average investor tends to capture a return of about 4% a year. In this case, some investors would seem to be better of just ignoring the volatility of shares and investing in a simple cash account.


It has been a challenging period for investors in which they have had to endure severe volatility, the worst aspect of share ownership. However, the historical rationale for owning shares has been their ability to return to investors a higher return that a simple cash investment.

At a time like this when the markets have been badly battered by the global financial crisis, it is interesting to reflect on the data from these two studies to look at returns that have been achieved, in considering the place that shares have in your portfolio in the future.