DB Wood Team
23rd September, 2022
Blog, IC Insights
Why losing money can be good for your long term wealth
“Hang on a minute, that does seem like a bold title amongst the current market challenges”. It is, but to try to explain, this week we are taking it back to basics.
The starting point is that an investment return is a function of two components:
Income Return + Capital Return = Overall Return
To start with the juicier bit, the capital return, that’s the result of prices moving up or down based on sentiment getting better or worse. If, for example, profits are higher than expected, prices can quickly move up to reflect that. On the other hand, if the economic environment looks more challenging, prices tend to fall.
The income return is the comparatively boring, stable bit. It’s based on what companies can sustainably pay out to shareholders or bondholders whilst continuing to achieve the rest of their business goals. Whilst positive capital returns require things to get better, income returns remain much more stable, particularly if the company has a robust balance sheet.
Income returns therefore tend to be more predictable, but they are also related to price. Take a company that declares a dividend of £4 per share – if their share price is £100, then your income return is 4%, but if their share price is £200, then your income return is 2%. Higher prices, or in other words, more expensive assets, lead to lower income returns.
We’ve talked in several blogs this year about the re-pricing of fixed-income assets (or bonds). A decade of low interest rates and inflation had pushed bond prices higher and higher, causing income returns to fall further and further. Getting predictable returns from bonds had become extremely hard, and it caused investors generally to head higher up the risk scale.
This year things have changed; the selloff in asset values has moved income yields up to levels we have not seen since coming out of the financial crisis. We have been adding to these positions all year and continue to do so. It has been painful as the market has continued to struggle in the short-term, but the key point is that we are buying investments that offer a solid return profile over the many years ahead. In this respect it is fair to say that there is lots of value around at present.
This will become a big positive for those with a medium to long-term investing horizon. Put a different way, it might be interesting to consider which of the following two options would you prefer:
1) A 2% return every year for 10 years
2) A 10% loss in capital in year 1, then 6% per annum for the remaining 9 years
The maths is detailed below. If you invested £100,000 and received returns of 2% per annum you would have £124,337 after 10 years. In comparison however, had you invested the same amount, lost 10% in the first year but then received 6% per annum thereafter, you would finish with £161,176. A much higher compound annual return of 4.9%.
This is all notwithstanding an extremely hard investment environment year-to-date. However, we also often get the question – how are we so optimistic? One key reason is because the income yields on our portfolios are so much higher. When income returns were historically low, the unpredictable part of your return was the overriding driver. Now that we have seen a considerable market correction, and our portfolios are generating around 4% in income, we have a much more predictable starting point.
Therefore, in addition to a greater chance of an improved longer term outcome, the market reset we have seen this year also gives us much more protection from further falls in the short term. Specifically, for low-risk investors with around 25% in equity exposure, those markets would need to fall a further 10-15% from here for those clients to have an overall negative return over the next 12 months. Portfolios are, therefore, now far more robust than 6 months ago and have far more opportunity to offset the challenges of rising inflation.
There has been a seismic shift in the investment landscape this year, most of which has been a result of tightening monetary policy in response to rising inflation. The outcome has led to a much better balance of power between the income and capital components of returns. This should provide both greater protection from further falls and a higher probability of a better long term outcome.