Where do investment returns come from?

People invest for two main reasons – to grow their wealth or to protect their existing wealth. We seek to grow our wealth to reach financial goals, such as buying a home, starting a business, paying for children’s education or funding our retirement.

Wealth is generated over the long term by investing in a portfolio of assets, including shares, bonds, property and cash. All investing involves a degree of risk and there is no asset that is entirely risk-free. But, generally speaking, the more risk you are prepared to live with, the higher the returns you should expect to receive.

Of course, not everyone needs to invest. If you feel you already have enough to meet your goals, you may decide to simply put your money in the bank. But few of us are in that position, which means that to generate a large enough retirement pot, we need to take on some risk. It’s worth bearing in mind that not taking on risk can be a risk in itself, as you could end up short of your target and find yourself having to work longer, spend less in retirement or take more risk later to catch up.

Bonds and shares

As an investor, there are basically two things you can do with your money to make it grow. You can either lend it to someone or become a part owner of a company. Let’s look at each of those in turn.

When you buy a bond, you’re lending money, either to a business or a government. The returns you receive comprise the interest paid on the loan (the ‘coupon’) and the expected capital return (the change in price). As a creditor, you’re nearer the front of the queue should the bond issuer default. Bonds are therefore safer than shares, but have a lower expected return.

When you buy a share, you’re getting part ownership of the business. Your returns in this case come from the share of the profits paid out as dividends and the expected capital return (the change in the share price). Being a share owner, you rank behind the creditors if the company goes bust. You should therefore expect a premium for investing in shares over bonds.

So, different asset classes come with different risks and different rates of return. Generally, cash is seen as the safest, but it also delivers the lowest returns. You could take on slightly more risk and invest in the highest-rated government bonds and expect a higher return than just cash. Corporate bonds are another step up from there. And, finally, you can target the highest expected return by investing in equities, or shares. Even within the equity universe, there are additional premiums available from small, low relative price and more profitable companies.

The flipside of the higher returns is greater volatility from year to year. In short, shares offer a bumpier ride. But the longer your investment horizon, the less these ups and downs matter. You can moderate the bumps and increase the reliability by diversifying.

What is the right portfolio for you? It depends on a range of factors, including your individual circumstances, risk appetite and time horizon. Ultimately, the best portfolio is the one you are able to stick with, even when markets are at their most turbulent.

What we do know is that markets, over time, have a history of rewarding investors who exercise patience and discipline, and who can live with the risk in expectation of the return.

Risk factors

Over several decades, financial academics have discovered a number of factors, often referred to as risk factors, that drive returns in the long term. These factors are evident in markets around the world and over long time periods:

The market: There is a premium available from investing in a broadly diversified portfolio of shares, as opposed to putting all your money in the safest government bonds. This is called the market premium. Shares are more volatile than bonds, but have a higher expected return.

Size, relative price, profitability: Within the equity market itself, there are three other premiums. Small companies have been shown to offer a higher expected return than large companies over time. Likewise, low relative price or ‘value’ stocks have delivered a long-term premium over high relative price or ‘growth’ stocks. Finally, more profitable companies have delivered a long-term premium over less profitable ones. Like the equity premium itself, these size, value and profitability premiums come and go. Then again, if they were there all the time, there would be no premium.

Term and credit: Within the bond market, there are two premiums -term and credit. Term refers to how long the bond has until it matures. This can range from a few months to 30 years or more. Generally, the longer the term, the higher the expected return. The credit factor refers to the likelihood of the bond defaulting. Generally, there is a premium for investing in bonds with lower credit quality. However, these term and credit premiums (as with the equity, size, value and profitability premiums) are not constant over time.

In summary, financial economists have built a strong sense of what drives returns over the long term. Investors can build diverse portfolios around these long-term drivers, trading off risk and return according to their own tolerances, circumstances, goals and time horizons.

The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.

This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action.

Tax and Estate Planning Services are not regulated by the Financial Conduct Authority.