Deciding where to invest money that has been saved is a nice ‘problem’ to have. However, it can be difficult to decide where to invest for the long term.
Shares have been a means of accessing relatively high returns in the past, but they can be risky compared with other assets such as bonds, cash and property.
Should an investor look outside the stock market in order to obtain a more favourable risk/reward ratio? Or are shares a good investment?
The risks involved in buying shares
Investing in shares can be riskier than other mainstream investments. The UK stock market has experienced two major bear markets in the last 20 years, with the dotcom bubble and the financial crisis causing prices across the FTSE 350 to come under significant pressure.
In contrast, investing in a cash ISA could be less risky than buying shares. Provided an individual has no more than £85,000 invested in each banking group, their capital will not be at risk of loss. Likewise, investment-grade bonds could offer less risk than shares, since debtholders have priority over shareholders in the case of financial difficulty.
Some individuals may think that investing in property is less risky than investing in shares shares. While house prices have delivered significant growth in recent decades, they have also experienced major falls during that time. With many buy-to-let investments being majority-funded through debt, there could be the potential for an individual to lose more than their initial investment. It is also more difficult to liquidate buy-to-let investments, while diversification in property is challenging compared with the situation when buying shares.
But what about the returns?
For long-term investors, shares could be of interest. Over the long run, shares are very likely to outperform their mainstream asset peers, with the FTSE 250 having recorded an annualised total return of 9% over the last 20 years.
While the same performance may not be achieved every year, I believe the FTSE 250 index is likely to outperform the 1.5% interest rate currently offered on some cash ISAs. In fact, over the long term, cash savings could fail to keep pace with inflation, gradually eroding an individual’s purchasing power.
I think that the returns on shares are also likely to be ahead of those on investment-grade bonds. The return on bonds could be negatively impacted by the prospect of a rising interest rate, which could increase their yields and cause their prices to fall. Although a tighter monetary policy may also hold back the stock market to some extent, it could have a more pronounced impact on bond prices.
Meanwhile, returns on property are set to be impacted by tax changes. A 3% stamp duty surcharge on second homes alongside greater restrictions on offsetting mortgage interest payments against rental income could reduce net returns for landlords. The prospect of rising interest rates may also make it more difficult for buy-to-let investors to access mortgages.
And the verdict is…
While shares can experience significant falls in the short run, over the long run the UK stock market has recorded relatively high returns. Therefore, buying shares in a range of companies in order to moderate overall risk could be a good move for long-term-oriented investors. Put another way, shares may experience significant paper losses in the short run, but in the long term their overall returns could be ahead of the profit made on other investments.
Furthermore, with cash savings offering a negative return once inflation is factored in and bonds likely to see their prices come under pressure from potential interest rate rises, there are possible risks ahead outside the stock market. Similarly, property investment has an uncertain future.
As such, while investing in the stock market may have associated risks, if you ask me, its overall appeal versus investing in other mainstream assets appears to be high.