The five to seven-year myth

Summary: The Australian share market is still 15 per cent short of the peak it reached a decade ago. For investors watching overseas markets reach dizzying new highs, the local performance is disappointing.

Key take-out: But don't look just at the straight index – the real investment story is in accumulation and franking credits. And five to seven years as a total timeframe, at any time, won't really add up to maximum returns.

Anniversaries are interesting times – perhaps a time to reflect on what can be learned from a relationship or experience.

The Australian share market celebrated an interesting anniversary recently – being 10-years since it hit its record high of 6828 points in November of 2007. As I write this article the market is trading at just under 6000 points (as measured by the ASX 200) – still down the best part of 15 per cent over a 10-year period.

In contrast the United States (and other markets around the world) are hitting record highs. So what can investors learn from this Australian 10-year anniversary?

The myth of five to seven years

I can remember my first exposure to investing in shares through managed funds – reading through a number of prospectuses to choose my first Australian share investment.

Most of them talked about a timeframe of five to seven years for a share investment. Some still do. This sort of advice is somewhat interesting in terms of our current experience that shows a 10-year period of average negative price returns from the Australian share market.

Is it really reasonable to expect a successful investment return from a shorter period given the current experience?

To put this in perspective, the 10-year return to the end of September 2017 for the Colonial Australian Share Fund is 2.59 per cent (very similar to the average return from the overall market). It's hardly a successful investment experience given the volatility of the 10-year period in question, and the higher (on average over that period) return available from a risk-free cash investment.

Of course, we should keep in mind that this has been a particularly challenging investment period – but one that shows that expecting a positive share market investment experience from a timeframe of five to seven years might need thought.

Price vs accumulation indices

I think that there is a case that can be made that the index we hear about each day on the news, most commonly the ASX 200 or All Ordinaries price index, is somewhat overrated as a measure of share market returns.

Likewise, the ‘total returns' or ‘accumulation' index that we less frequently come across is a somewhat underrated measure of share market performance.

The ASX 200 index is a measure of performance of the largest 200 companies on the Australian market. It is a ‘market capitalisation weighted index', which means that movements in the price of the largest companies in the index (the banks, BHP, Telstra, Woolworths, for example) have the biggest impact on the value of the index. It is a ‘price index', which means that it measures the change in price of the 200 companies each day. This index is the one we hear about each day, measuring that there has been a rise or fall of some percentage in the ASX 200 index on that day.

As well as a price index, there is also an ASX 200 ‘total returns' or ‘accumulation' index. This index measures both the movement in price of the shares and the dividends paid. In any given day the daily movement of the ASX 200 price index and ASX 200 accumulation will be almost exactly the same.

However, over longer periods, the fact that the ASX 200 index includes dividends will see it better replicate the experience of investors who receive the dividends from the shares that they own. Those dividends provide an additional annual return of around 4 per cent a year – an amount worth measuring through an accumulation index.

Indeed, if we go back to our 2007 to 2017 time period, we can see the difference between using the ASX 200 index vs the ASX 200 accumulation index. The ASX 200 index is down nearly 15 per cent between the November 2007 high and now. However, the ASX 200 accumulation index provides a different, and more complete story.

It hit a high of 42,356 points in 2007. However, rather than falling over the subsequent 10-year period, it is now trading at just under 60,000 points. So, while investors have seen the price of the average portfolio of shares (as measured by the ASX 200 index) fall in value by 15 per cent, they have received annual dividends that has more than offset the fall in value of their shares. In fact, they have achieved a total return of 40 per cent over the 10-year period.

The one element that is missing from these indices at the moment is the value of franking credits, which provide a benefit equal to that of a cash distribution to investors. Some Australian indices are now using franking credits in their calculations.

Applying this methodology to a broad-based index like the ASX 200 index will provide more valuable information for investors, given that the value of franking credits from the average market will be in the range of an extra 1 per cent to 1.5 per cent a year. Let's hope the ASX 200 Accumulation with Franking Credit Index is not far away.

How long to the price index hits a record high?

I am currently doing some travel through Mexico, Cuba and the US, and have been hearing the enthusiastic reporting of the US share market hitting record highs. So, it is interesting to consider the question of when we might hit a new high on our price indices here? We are currently 15 per cent below our all-time level.

The ASX Russell Long Term Investing Report (2017) showed that the total return from investing in shares for the 20 years to the end of December last year was 8.5 per cent per annum. If we assume that 4 per cent per year of this is dividends, that leaves an average price return of 4.5 per cent per annum – meaning a new record high in the price index would be about three years away.

However, if we look at individual years of returns since 1900 (116 years of data to the end of 2016) there have been 30 years where share market returns have been 20 per cent or greater in a year. If 2018 were to fit into this category, a new share market high could be only months away. Equally, there have been 10 years where returns have been negative 10 per cent or worse, which would set the likely timeframe for a new market record high back somewhat. The bottom line is that, while it might be fun to speculate, it is just speculation.

Conclusion

Five to seven years as a timeframe for investing in growth assets like shares might not be long enough to have a high certainty of investment success – as shown by the Australian share market data from 2007 to now.

While we are thinking about share market returns there is a case that, as investors, we should be aware of both price and accumulation indices.

As for the next market high, any thoughts are nothing more than a guess – although looking back to when statistics for the Australian market first began in the late 1800s, we can say with certainty that every time markets have fallen – including for events as serious as the Great Depression – they have always recovered to hit new highs.