|Summary: Historic patterns on the ASX show that sharemarket income is remarkably reliable over almost any time period – and 2014 will not be different.|
|Key take-out: Based on the performance of the sharemarket over the past two years, it would not be unreasonable to expect a return from Australian equities in 2014 of 12%.|
|Key beneficiaries: General investors. Category: Asset allocation.|
At the start of a new investment year there are probably any number of thoughts that people have in relation to their financial situations, including resolutions, the reorganisation of individual investments and, one of the biggest decisions of all, asset allocation.
In 2014 investors will be keenly aware we are returning, it seems, to what might be described as more normalised returns. The spectre of the global financial crisis has faded and the last two years of sharemarket returns have been very healthy. In terms of simple price appreciation, how much higher did the ASX 200 finish last year from where it started? The answer is roughly 14%, about the same number as it grew in calendar 2012.
Emboldened by these returns and disappointed with rock-bottom returns from cash and many bonds, investors don’t want to miss a similar performance in calendar 2014. Of course, we never know what will happen in the future but it would not be unreasonable to expect a return in 2014 of 12%.
Assuming you’ve already decided to move back into the market, one of the biggest decisions you need to make next is whether your focus is on price growth (i.e. how high might your shares rise) or income (what dividend flow might you expect from the shares). As you’ll see from some of the research I’ve done for Eureka Report, income from shares in the Australian market is often underestimated.
The volatility of shares – halving in Australia in value during the Great Depression, the 1970s, 1987 and the GFC– is counterbalanced by the fact that returns from shares are attractive compared to other asset classes. Over the past 35 years (since January 1, 1979) Australian shares have provided an average return of 12.7% a year (source: Vanguard). Longer-term studies into Australian sharemarket returns suggest that this is a reasonable approximation of returns. Very few asset classes have consistently provided this level of return, a rate of return that will double a portfolio in six years (although this is a statistic that seems a little hard to accept given that markets are down some 25% over the past six years).
This volatility creates a challenge. It is great to have shares in a portfolio for their superior long-run returns, however they are difficult to own due to their volatility. In fact, investors face an even bigger challenge here – there is evidence to suggest that we as investors do a poor job of timing investments into the market. When markets are high, we tend to get enthusiastic about recent good returns and want to invest. When markets are low, we tend to become cautious and reduce our sharemarket investments.
One frame of reference that I often use when thinking about sharemarket investments is to split it into two asset classes: sharemarket income and sharemarket growth.
Sharemarket income – which many ‘value investors’ suggest should be a key focus of investment efforts – is a wonderful asset class when you come to think about it:
- It has significant tax advantages.
- It never provides a negative return.
- It tends to increase over time.
This contrasts sharply with sharemarket growth, which can provide negative returns, with an average portfolio in the Australian market losing up to 50% of its value during the worst market downturns.
In an attempt to look a little further into the characteristics of sharemarket growth and sharemarket income, I have gone back to July 1985 through to the end of June 2013 and used the index values for the ASX 200 index (which only measures price movements) and the ASX 200 Accumulation Index (which measures price and income) to compare the return from capital growth and income (dividends).
The following table gives the ‘summary statistics’ for sharemarket income and growth over this period (July 1985 to June 2013):
Capital Growth Return
Average Annual Return
Standard Deviation of Return
Over this period, the average market return from growth (6.8%) has been higher than the return from income (4.5%). However the income figure does not take into account the benefits of franking credits, which will add an extra 2% a year if the shares provide income of 4.5% a year fully franked. In other words when you include the distinct advantages of our tax system, on a take-home or ‘hip pocket’ basis the income from Australian shares is much higher than many realise.
And that’s before we even consider the standard deviation that measures the spread, or volatility, of returns. This is where there is a stark difference in the returns between growth and income – sharemarket growth is extremely volatile (15.8%), whereas the income return is almost cash like in its lack of volatility (0.7%).
This analysis so far only tells part of the story. That the income from shares is relatively reliable – but it has an extra crucial benefit of tending to grow over time.
The following chart shows the average sharemarket income since the 1986 financial year – for a portfolio that earned $1,000 of income in that first year. It is assumed that the income each year is spent – it is not re-invested in the portfolio. (If it was re-invested then the income would grow more quickly over time).
You can see that at times the income from the portfolio has fallen (during the 1990s recession and GFC), but that it has clearly tended to grow over time. We can calculate the growth rate of income over this time, and find that it was 6.2% a year, which was well above the rate of inflation over the same period. This is important for investors, particularly those planning retirement, as it means that the purchasing power of their income from their investments has not decreased.
A question might be: what is a reasonable expectation for the growth of dividends over time? There are various factors that might influence this, including how much money companies are investing in new projects and economic conditions. However, a not unreasonable assumption is that dividends might grow at the same rate as the economy (as measured by Gross Domestic Product). An average for GDP of around 3% has been normal for Australia – however this figure is a measure of ‘real’ GDP growth, which is after inflation has been taken into account. If inflation is 3% a year, then the economy is actually growing at 6% a year, in line with the 6.2% growth in dividends calculated for the period we have looked at.
The following graph takes into account the value of franking credits (assuming average franking levels of 70% across the market) since their introduction.
It remains obvious from a variety of sources – including the strength of deposit income at the major banks – that Australian retail investors still have significant holdings in cash, as the sharemarket losses of recent years has spurred widespread conservatism.
But we should not understate the value of income from our share portfolio. A lot of the media focus is on share price movement – capital growth – and that ‘s all fine.
Over long periods of time (10-15 years plus) positive capital growth is highly reliable. However, in the shorter time it is the income from shares that provides a reliable source of returns, coupled with the tax benefits of franking credits and income growth over time.
Perhaps it is the perfect asset class – reliable, tax advantaged and growing at a rate greater than inflation. It’s just that at this stage it comes ‘joined at the hip’ with capital growth – which causes many investors to buy, sell and change course over time, never fully getting the benefits from the wonderful asset class that is dividends from shares owned over time.
Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.
* This article is part of the “It's Time” series in Eureka Report focussing on new opportunities for investors in 2014. Click here to see the entire series.