Equity SSIAs may help bring stock investment back into favour

Serious Money: To an already sceptical audience, the Eircom flotation in 1999 at the height of the technology and telecom bubble confirmed in the majority of Irish people's minds that equity (share) investing was risky and more akin to gambling, with good rewards to be had only by those "in the know".

Most small investors lost money on Eircom with many vowing never to return to the stock market.

However, the Government may soon be able to claim some redemption as a consequence of Special Savings Incentive Accounts (SSIAs) in 2001, which encouraged investors to save steadily for a five-year period. At this stage, those who have chosen to save through an SSIA equity product look destined to come out with better returns compared to those who saved through cash deposits.

Regular monthly investing will have played a critical part in the achievement of these better returns as, despite the volatility of the stock market in the interim, it has allowed investors to "average" into the markets. This should serve as a welcome reminder of the positive attributes of saving through the stock market.

These positive attributes are worth reiterating. An individual can start saving from a very modest base and quickly achieve diversification with each additional amount saved. This is in marked contrast to investing in property - where one needs a substantial stake to get started (or a lenient mortgage provider) and diversification can only be achieved in the longer term.

Indeed, the dreaded demon of "stock market volatility" is much less likely to unnerve the regular investor. For example, look at the returns and the volatility of those returns for an individual who invested $100 (€75) in the US stock market at the start of 1970 and continued to invest $100 each month thereafter up to the present day. Over that 35-year period, an investor would have invested $42,400 in the market and would today have an investment worth $290,000 excluding dividends or about $585,000 if the dividends received had been reinvested at the end of each year.

This represents a compound return of 7.8 per cent per annum, excluding dividends, and 11 per cent with dividends reinvested.

The graph highlights what a $100 investment was worth after a five-year period irrespective of when an investor started to invest. What should be obvious is that returns can be volatile and lumpy.

There have been numerous periods in the 1970s and since early 2000 when a $100 investment was worth less than that amount after five years. That's the nature of the beast but, by committing to a regular saving plan through the ups and downs of the stock market cycle, an investor can avoid the trap of committing all of his/her capital when stocks are overvalued, which is generally only obvious in hindsight.

Even over a shorter time frame, the message is the same. An investor who started saving $100 a month from the start of 1990 would have invested $18,300 and would today have an investment worth $37,030 excluding dividend income or $50,100 with dividends reinvested. Over this 15-year period, this represents a 9.8 per cent compound return per annum before dividend income or 12 per cent per annum with dividends reinvested.

Another striking feature of this type of analysis is the power of compounding, which only really starts to kick in after about seven or eight years. For example, while a 10 per cent return on the initial $100 invested might seem small at $10, a 10 per cent return on your investment today, had you started in 1990, would be $3,700 or $5,000 depending on whether or not you reinvested the dividends. And that is compared to the total investment of $18,300 that you have made over that period and represents an annual return of 20-27 per cent and rising.

The lessons from this analysis are clear - everyone can achieve reasonable returns through the stock market if they commit to a medium-term plan, where the power of compounding works wonderfully over time.

Success with the SSIA equity products should go a long way to dispelling the notion that the stock market is unduly risky. Irish people have been good savers over the years and initiatives which encourage a widespread long-term savings mentality in Irish society are healthy.

To this end, it would be a shame if the "compounding" benefits that are just starting to accrue were to be cut short once the initial five-year SSIA timeline has lapsed.

The argument in favour of extending the timeline on these accounts or allowing for a transfer of monies saved into pension accounts in a tax efficient way looks strong to me. The Government would also be a winner longer term.

Rory Gillen is head of research in Merrion Stockbrokers.