Rhymer Rigby explores the track record of gilts and equities and seeks to answer one of the oldest investment chestnuts: which is the better home for the long-term investor?
The first recorded UK share issue took place in 1553, when, for 'five and twenty pounds and a piece', 16th-century punters could buy a stake in the Muscovy Trading Company. The precedent set, other firms - such as the East India Company and the Hudson Bay Company, the world's oldest listed business - followed suit. By 1695, there were around 140 joint stock companies with a combined market value of £4.5 million.
Gilts, or government securities, which took off in financing the Napoleonic Wars, also have a lengthy pedigree. But it was not until this century that records enabled a realistic calculation of their average yields and returns.
Of the two it is gilts that have typically been regarded as the natural home for long-term investors seeking security and a decent return. In this, little has changed since Victorian times, when the advice to any young man coming into money was: 'Put it into Consols, my boy.'
Equities, despite their long antecedents, are still associated with risk. 'There are two times in a man's life when he shouldn't speculate: when he can't afford it, and when he can,' Mark Twain famously said. And he had equities in mind. Whenever the stock market falls, there are echoes of Twain in the comments of many pundits.
In fact, looked at with a long-term perspective, gilts have been a lousy investment, while equities have offered excellent returns. This year's BZW Equity-Gilt Study (an annual exercise conducted since 1956 on the basis of data going back to 1918), points out that £100 invested in equities in 1918, with gross income reinvested, would be worth nearly £30,000 now, even after adjusting for inflation. A similar investment in gilts, in contrast, would be worth a mere £500 (see graph below).
Why is this? The value of equities, clearly, reflects the two key variables that determine an economy's performance: growth and inflation. When there is dull growth (prolonged slump followed by recovery) and low inflation, or even falling prices, as in the inter-war years, the environment for equities was a poor one. Equity investors did marginally better than holders of gilts between 1918 and 1939 but neither had much to write home about.
The post-war period, then, represents the real flowering of the cult of the equity. During the early to mid-1950s, as the nation emerged from wartime austerity the realisation dawned that the economic climate was very different from that in the pre-war period, and was highly favourable for equities. Economic growth, helped by a sharp expansion of world trade, was robust. Meanwhile, creeping inflation was apparently a permanent condition. 'There was a one-off revaluation of equities,' says Phil Adams, one of the authors of the BZW study. 'People suddenly realised that if you buy equities, you are buying future growth.'
Gilts, in contrast, cannot offer such attractions for investors. A gilt is a contract with the government. When it borrows £100 from you by selling you a gilt, it will provide you with interest, but it will only pay back the original £100.
This revaluation of equities in the 1950s sparked the beginning of the opening-up of a substantial yields differential. Equity investors were prepared to accept low returns because of the added attraction of capital growth. The biggest influence on yields, however, was the need for holders of gilts to be compensated for sharply rising inflation. Gilt yields were at their highest when inflation (which touched 26% in 1975 and 22% in 1980) appeared out of control (see graph above).
More recently, yields have moved in a way which encourages the view that the inflation nightmare of the 1970s and '80s is over. The yield differential has narrowed and last year's real return on equities, minus 6.8%, was among the worst this century (but better than that on gilts). Is the cult of the equity over?
Almost certainly not. There have been bad years before, and there has been low inflation before. But equities have consistently outperformed gilts. Their real return over the 1919-'94 period averages 7.7% a year, against 1.8% for gilts. According to BZW: 'For long-term investors, the optimal mix of assets would include equities and possibly cash, but not gilts.' Don't invest in Consols, my boy.