Equities are also known as “stocks” or “shares”. As the name suggests, shares are a portion, or share, in the ownership of a company. If the company’s profits grow, or if steady profits are expected and delivered, the share is likely to increase in value. If the company’s profits fall, or even if they just come in below expectations, then the share is likely to fall in value.
In many countries equities are the core holding in most investment portfolios. This is because over the long run equities have tended to deliver higher returns than most other asset classes. However these high return prospects come with higher risk as equities tend to be prone to sharp swings in value.
Due to their high growth potential, equities should not be ignored, except by low risk and minimal risk investors. At the same time, moderation is advisable. Regardless of the long run potential, to put an entire portfolio in equities can be reckless unless your time horizon is very long or your risk tolerance is very high.
Characteristics of equities
The following are some important characteristics of equities:
- They often perform in unison in the short run, with prices falling or rising together with good or bad economic news
- They are very volatile – see below for some historic statistics on gains and losses
- They tend to anticipate economic trends rather than to follow them
Equities have the potential to offer substantial returns when they perform well
The following statistics illustrate the substantial investment returns that equities can deliver. The statistics refer to the US equity market in the twentieth century, chosen both because data for it is readily available and because it became over the course of the twentieth century the world’s most important stock market.
- The best calendar year for equities in the 20th Century was 1933, when they gained 59.6% in real terms, including dividends (i.e. equities gained 59.6% ahead of inflation)
- The best decade based on calendar years ran from 1989 to 1999 when equities gained 14.5% per annum in real terms, including dividends. Effectively, €10,000 invested in 1989 was worth €39,393 by 1999 even when adjusted downwards to take account of inflation.
- Historically, equities have outperformed cash in 2 out of 3 years*
Equities can also bring significant financial anxiety when they perform badly
The below statistics exhibit some of the significant losses that have resulted in periods when equities perform poorly. Again, these statistics refer to US equities in the twentieth century.
- The worst calendar year for equities in the same market was 1931, when they lost 40.4% in a single year in real terms, including dividends
- The worst decade based on calendar years ran from 1965 to 1975, and saw equities losing 4.2% per annum in real terms, including dividends. Effectively, €10,000 invested in 1965 was worth €6,511 by 1975 once adjusted downwards to take account of inflation.*
Equities are a long term investment
Taken as a whole, the US equity market has never lost money in real terms over any 20-year period. This is not to say it could never happen, as it has done in other markets.
Cash and government bonds, on the other hand, have lost value in real terms over 20 years and longer, due to the effects of inflation. Indeed the effect of inflation was such that an investor in UK government bonds in 1960 was still showing a loss in real terms as late as 1985, despite the UK government not defaulting during that 25-year period (or indeed since the 17th Century).*
There is a facet of equity markets that catches out even very experienced investors. Equity markets do not tend to follow economic trends – rather they tend to anticipate them.
If we examine the onset of the last economic recession we can see the power of equity markets in signalling a change in the prevailing economic trend. One can trace the course of that recession, which in the developed world, began in the middle of 2008 and worsened severely after the fall of Lehman Brothers in September 2008. Equity markets had been shaky from the middle of 2007, and began to fall sharply from January 2008.
The recovery in most regions did not really start until the last quarter of 2009. However equity markets hit bottom on 6 March 2009 and recovered very strongly from that point, gaining 44.8% in real terms by year end.
This is one of the factors that make it extremely hard to time equity markets. If you see a piece of bad economic news, the market sees it at the same time as you do, and probably earlier, since market traders spend their time watching for this kind of thing. This does not mean the market will always get it right, or that the market is necessarily ‘efficient’. After all, a fall in markets suggests that they rose too far in the first place and vice versa.
* Mercer's calculations regarding historic equity returns are based on figures from the Barclays Capital Equity/Gilt studies