For more than a decade, savings rates had been anaemic. Investors could expect no more than 1-2% interest on their cash holdings. Today, it is possible to get 4-5% interest on a savings account, which begs the question: Why invest in the stock market?
This is a pertinent question after a turbulent 18 months in stock markets. Stock markets saw a significant decline in 2022 and despite a better performance in 2023, have not yet reached their previous levels pre-2022. It is tempting to see 5% on cash as risk-free income, rather than put up with the caprices of stock markets.
Cash has a role in financial planning. It can help provide a safety net, bring some optionality to a portfolio, or fund short-term spending needs. But we would argue that for long-term savings, it is still important to invest in the stock market.
Inflation
The first point is on inflation. While cash savings rates look superficially high, they need to be set against the context of high inflation. If inflation is at 2%, a 5% income is attractive. If inflation is at 7%, then it is less appealing. Savings rates may have risen, but savers would still see the purchasing power of their capital diminishing. Over a 10-or 20-year time frame, this may become a significant drag on long-term savings.
The stock market has historically performed better than cash. The recent Barclays Equity Gilt Study showed that over the past decade, equities returned 8% per annum after adjusting for inflation. By contrast, cash lost 1.9% per year in real terms.
There are sound reasons for this. Companies may experience inflation in the form of higher costs, but they can also pass price rises onto their customers. This may help them maintain their profitability at times of higher inflation, which, in turn, may support share prices.
It should be said that this is not universal. Not all sectors have the ability to pass on price rises. Regulated sectors may be limited in the extent to which they can raise prices, for example, while some highly competitive consumer sectors may struggle to push through increases on under-pressure households. Therefore, some selectivity on companies and sectors is particularly important at times of high inflation.
Dividend growth
With cash holdings in the bank, the rate of interest is generally fixed, though banks may vary the interest rate. In contrast, companies could grow their dividends over time, and they aim to pay out progressively more to shareholders year after year.
For investment companies that invest in these firms, this allows them to target a progressive dividend policy that aims to build their payouts each year.
What does this look like in practice? If an investor buys a share at £100 and it pays a potential return income of £3.50 the share price may rise or fall, but if the dividend grows, that investor may be getting £3.75 next year, and £4.50 the year after, all from their original investment.
Volatility
Earnings from investments (dividends) are often steadier than the changing value of the investments themselves. This is because dividends depend on the operational performance of an individual company rather than market sentiment. The aggregate dividends of companies in the FTSE 100 have grown every year since 2015, except during the pandemic disruption of 2020.
For investment companies focused on income and growth, their aim is to focus on finding companies that generate sufficient cash to grow their payouts to shareholders over time. Uncovering these companies in the UK market – which has a rich history of paying dividends to shareholders – can allow investors to ensure their dividends grow over time, while also growing shareholder capital.
Rising interest rates have created a new landscape for investors, but higher interest rates do not derail the argument for stock market investment in the longer-term. Equities remain a potential tool to protect a portfolio against inflation, and to grow income over time.
David Goldman is manager of the BlackRock Income & Growth investment trust