Gilts should form the basis of every private investment portfolio, shouldn’t they?

It is hard to see how you can go wrong with a gilt-edged government bond, especially one that is index-linked. The government guarantee means that you are all but certain to get back what is promised, in capital and income terms. The index link means that gilt-edged savings retain buying power which would otherwise be eroded by inflation, and this week’s Inflation Report from the Bank of England suggests that inflation is something to worry about. The tax treatment of gilts, for personal investors, adds to the attraction.

The downside of gilts is that shares usually outperform over longer periods. To some that may not matter much, since the risk in gilts is so miniscule as to be widely thought nonexistent. But needless handicaps are borne by those with an overcautious approach to investment. They could garner more wealth more quickly. They could retire earlier. Data in the Barclays Equity Gilt Study, the 2008 edition of which was published this week, suggests that long-term returns from gilts are inferior to those won by shareholders. Over the past 50 years, says Barclays, gilts have risen by an average of 2.4 per cent a year in real, that is inflation-adjusted, terms. Shares have done three times better, producing 7.2 per cent a year.

Over shorter periods, however, the evidence is not nearly so convincing. Indeed, in the ten years to 2007 gilts produced higher real returns than shares (of 3.3 per cent compared with 3.1 per cent). Many will assume that data for 50 years deserves to be taken more seriously than data for ten years. But ten years’ data is substantial enough. It equates to a realistic investment-time horizon.

Maybe the ground rules commanding portfolio management have shifted. If you could be sure that equity-gilt returns of the past ten years would be mirrored over the next ten, everyone would shun shares and fill their boots with government bonds. When the riskiness of shares is taken into the equation the performance advantage of gilts looks unbeatable.

Demand from institutional pension-fund managers has flattered performance numbers. Concerns from pension-sponsoring employers about funding, coupled with regulatory obligations, heightened the attraction of gilts. The same pressures, working in reverse, undermined the prospects for shares. But who is to say that this is a temporary phenomenon, a short lived readjustment that is now complete? Barclays pointed out this week that gilts account for 26 per cent of the capital invested in a typical portfolio, but only 1 per cent of the risk. Pension-fund portfolio adjustments may have only just begun.

There is a place for gilts in most, if not all, portfolios. The older you get, and the more you value the knowledge that your savings will not shrink, the greater the role for gilts. But now is not the time to lose faith in equities. The graph (above left) encapsulates the reason why shares should continue to enjoy the preeminent position in investors’ thinking. Firstly, it sends a reminder that dividends on shares usually grow over time. The same cannot be said for gilts. It is not for nothing that gilts and other bonds are also known as fixed-interest securities. And since the income is fixed, the capital value is also anchored. Just as encouragingly, the graph shows that dividends on shares are rising strongly. The average for the past five years is, at 8.2 per cent a year, close to the postwar average.

Some of the recent growth comes about because corporates hoarded cash around the turn of the millennium, when it was peculiarly fashionable for corporates and many institutional investment managers to relegate the dividend in their lists of priorities. That odd fashion may well be the reason why shares have underperformed in the past decade, too.

If the developed world endures a period of slower economic growths companies may become less generous with dividend payouts. But companies appear to have rediscovered the attraction of dividends. Consider my personal favourite stock-market factoid, updated by Barclays this week. If you invested £1,000 in UK shares in 1945 the capital value of your investment, adjusted for inflation, would be £2,960 now. If you reinvested the dividends your £1,000 would now be worth £45,770. Wow.

Chuck in the fact that the FTSE all-share index gives a forward dividend yield of 4.2 per cent and sits on a prospective p/e ratio of 12 and the case for equities strengthens yet further. Buy the FTSE. robert.cole@thetimes.co.uk

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