Equities are Safe – In the Very Long Term
Although equities are, in the very long term, able to offer investors a risk premium – that is, they provide greater returns than less risky assets in return for taking on extra risk – they can fail to offer decent returns in the short-term. In fact if you don’ reinvest dividends they may fail to provide any return at all for long periods, but that’s another discussion. Because of this investors need to be wary of overinvesting in the stockmarket, being gulled by the apparently “safe” excess returns on offer.
Research by Rob Arnott has recently indicated that government bonds have returned more than shares at the index level over a forty year period. Now, we have been hovering around a market bottom recently but that’s no consolation if you’re on the verge of retiring. It’s a fact that stockmarket returns have been appalling for periods equating to a person’s entire investing lifetime.
Developing and Developed Markets
Within specific markets, especially developed ones like the US, Japan and the UK, returns have been levelling off for a while now. Generally speaking the early productivity gains for economies are in the early stages of development, while labour is cheap and the country has significant competitive advantages. The growth of the USA in the first part of the twentieth century easily outstripped that of the already industrialised UK, while Japan’s post World War II growth was, for forty years simply astonishing.
The problem with developing countries over developed is that they tend to be much more vulnerable to economic shocks and political upheaval. However, the trend is clear – the stockmarkets of developing nations tend to provide better returns than the stockmarkets of developed nations.
The Familiarity Effect
By and large, though, people will overinvest in the stockmarkets they understand and under-invest in those they don’t. This is a manifestation of the behavioural bias known as the familiarity effect, which means we feel more comfortable with that with which we’re more familiar. This effect extends beyond stockmarkets to individual stocks: private investors buy more of the stocks and the stories they’re comfortable with than those they haven’t heard of – which indicates, if nothing else, that their stock research methods are faulty. This isn’t the best way of finding stock investments, ask Enron employees many of whom had their life savings invested in Enron stock and were comfortable with it.
The reason for this digression into behavioural psychology is twofold – firstly private investors tend to invest overwhelmingly in their home stockmarkets and secondly they tend to invest overwhelmingly in the asset classes with which they’re most familiar – stocks, property and cash. For most investors asset class allocation is more important than allocating investments within classes so understanding what asset classes are available is crucial.
Correlation of Asset Classes
Basically different asset classes are more or less correlated. That is, they move together or not to a different extent. In the past couple of years most asset classes have lined up and moved together, but that’s unusual. Even so developing stockmarkets and government bonds have outperformed and having some of those in your portfolio would have mitigated losses in the overall portfolio.
At a high level the types of asset classes we’re talking about are developed stockmarkets, developing stockmarkets, government or corporate bonds, industrial commodities (e.g. copper), precious metals (e.g. gold), real-estate and cash. There are significant variations within some of these classes – so within the stock investments you can divide these into growth and value, where value tends to generate higher returns over time, or into large-cap and small-cap, where there’s variable evidence that small-cap provides a slightly higher return.
There are also tax considerations to consider, dependent on your local jurisdiction’s laws. These may bias you in favour of one or other of these classes but generally you shouldn’t let tax considerations overwhelm your overall asset class requirements.
Constructing an Asset Class Weighted Portfolio
The big question, really, is what proportion of your investment monies to put into each class and there, I’m afraid, you need to make your own decisions. It’s hugely dependent on age, health, earnings prospects and attitude to risk. Someone who’s in their fifties, in good health, looking to retire soon and looking at thirty years of retirement needs to be a good deal more cautious than someone in the early thirties and just starting to climb the corporate ladder.
As I don’t (and won’t ever) offer direct investment advice at this point I’d suggest people read something like William Bernstein’s Four Pillars of Investing which goes over these issues in much more detail. One of Bernstein’s tables is reproduced here, where the left hand column indicates the % of your stock portfolio which you’re prepared to risk losing in order to earn higher returns. This is a function of volatility – stocks can and do go up and down much more than other, less risky asset classes.
And, as Bernstein states: “Realize this is only a starting point”.
Rebalancing
The other side to asset class management is the concept of rebalancing. In any given time period you’d expect one or more of the asset classes to outperform and to grow as a percentage of the total portfolio. However, if we believe that mean regression is the overwhelming factor behind asset class movements we’re expect that over some, undefined period, that the outperformers will turn into the underperformers and vice versa. Therefore, the concept of occasionally rebalancing – selling some of the winners to invest in the losers – potentially offers a way of gently increasing our overall returns. It also helps maintain the risk profile of the portfolio, of course.
Opinion is divided on how often you should rebalance. Rebalancing involves trading and trading involves costs and costs reduce the overall return on your assets, so the basic answer is “not very often”. Three years or five years seem to be the preferred options, but you pays your money and you takes your choice. Finally, the balance of investments within a portfolio should change over an investor’s lifetime as their wealth, health and other factors change. Making these modifications at the standard rebalancing time is the simplest thing to do, but it’s important to keep this under review.
Index Tracking
Whereas once upon a time building a multi-asset class portfolio like this would have been a pipe dream for most small investors increasingly it’s a practical possibility due to the wider availability of index trackers and ETF’s which offer low cost access to portfolios of assets. Which is something we’ll look more closely at next time.
Last Post: Stepping Stone #3: Understanding Stockmarket History
Next Post: Stepping Stone #5: Know Your Limitations. KISS
Although equities are, in the very long term, able to offer investors a risk premium – that is, they provide greater returns than less risky assets in return for taking on extra risk – they can fail to offer decent returns in the short-term. In fact if you don’ reinvest dividends they may fail to provide any return at all for long periods, but that’s another discussion. Because of this investors need to be wary of overinvesting in the stockmarket, being gulled by the apparently “safe” excess returns on offer.
Research by Rob Arnott has recently indicated that government bonds have returned more than shares at the index level over a forty year period. Now, we have been hovering around a market bottom recently but that’s no consolation if you’re on the verge of retiring. It’s a fact that stockmarket returns have been appalling for periods equating to a person’s entire investing lifetime.
Developing and Developed Markets
Within specific markets, especially developed ones like the US, Japan and the UK, returns have been levelling off for a while now. Generally speaking the early productivity gains for economies are in the early stages of development, while labour is cheap and the country has significant competitive advantages. The growth of the USA in the first part of the twentieth century easily outstripped that of the already industrialised UK, while Japan’s post World War II growth was, for forty years simply astonishing.
The problem with developing countries over developed is that they tend to be much more vulnerable to economic shocks and political upheaval. However, the trend is clear – the stockmarkets of developing nations tend to provide better returns than the stockmarkets of developed nations.
The Familiarity Effect
By and large, though, people will overinvest in the stockmarkets they understand and under-invest in those they don’t. This is a manifestation of the behavioural bias known as the familiarity effect, which means we feel more comfortable with that with which we’re more familiar. This effect extends beyond stockmarkets to individual stocks: private investors buy more of the stocks and the stories they’re comfortable with than those they haven’t heard of – which indicates, if nothing else, that their stock research methods are faulty. This isn’t the best way of finding stock investments, ask Enron employees many of whom had their life savings invested in Enron stock and were comfortable with it.
The reason for this digression into behavioural psychology is twofold – firstly private investors tend to invest overwhelmingly in their home stockmarkets and secondly they tend to invest overwhelmingly in the asset classes with which they’re most familiar – stocks, property and cash. For most investors asset class allocation is more important than allocating investments within classes so understanding what asset classes are available is crucial.
Correlation of Asset Classes
Basically different asset classes are more or less correlated. That is, they move together or not to a different extent. In the past couple of years most asset classes have lined up and moved together, but that’s unusual. Even so developing stockmarkets and government bonds have outperformed and having some of those in your portfolio would have mitigated losses in the overall portfolio.
At a high level the types of asset classes we’re talking about are developed stockmarkets, developing stockmarkets, government or corporate bonds, industrial commodities (e.g. copper), precious metals (e.g. gold), real-estate and cash. There are significant variations within some of these classes – so within the stock investments you can divide these into growth and value, where value tends to generate higher returns over time, or into large-cap and small-cap, where there’s variable evidence that small-cap provides a slightly higher return.
There are also tax considerations to consider, dependent on your local jurisdiction’s laws. These may bias you in favour of one or other of these classes but generally you shouldn’t let tax considerations overwhelm your overall asset class requirements.
Constructing an Asset Class Weighted Portfolio
The big question, really, is what proportion of your investment monies to put into each class and there, I’m afraid, you need to make your own decisions. It’s hugely dependent on age, health, earnings prospects and attitude to risk. Someone who’s in their fifties, in good health, looking to retire soon and looking at thirty years of retirement needs to be a good deal more cautious than someone in the early thirties and just starting to climb the corporate ladder.
As I don’t (and won’t ever) offer direct investment advice at this point I’d suggest people read something like William Bernstein’s Four Pillars of Investing which goes over these issues in much more detail. One of Bernstein’s tables is reproduced here, where the left hand column indicates the % of your stock portfolio which you’re prepared to risk losing in order to earn higher returns. This is a function of volatility – stocks can and do go up and down much more than other, less risky asset classes.
| I can tolerate losing ___ % of my portfolio in the course of earning higher returns: | Percent of my portfolio invested in stocks: |
| 35% | 80% |
| 30% | 70% |
| 25% | 60% |
| 20% | 50% |
| 15% | 40% |
| 10% | 30% |
| 5% | 20% |
| 0% | 10% |
And, as Bernstein states: “Realize this is only a starting point”.
Rebalancing
The other side to asset class management is the concept of rebalancing. In any given time period you’d expect one or more of the asset classes to outperform and to grow as a percentage of the total portfolio. However, if we believe that mean regression is the overwhelming factor behind asset class movements we’re expect that over some, undefined period, that the outperformers will turn into the underperformers and vice versa. Therefore, the concept of occasionally rebalancing – selling some of the winners to invest in the losers – potentially offers a way of gently increasing our overall returns. It also helps maintain the risk profile of the portfolio, of course.
Opinion is divided on how often you should rebalance. Rebalancing involves trading and trading involves costs and costs reduce the overall return on your assets, so the basic answer is “not very often”. Three years or five years seem to be the preferred options, but you pays your money and you takes your choice. Finally, the balance of investments within a portfolio should change over an investor’s lifetime as their wealth, health and other factors change. Making these modifications at the standard rebalancing time is the simplest thing to do, but it’s important to keep this under review.
Index Tracking
Whereas once upon a time building a multi-asset class portfolio like this would have been a pipe dream for most small investors increasingly it’s a practical possibility due to the wider availability of index trackers and ETF’s which offer low cost access to portfolios of assets. Which is something we’ll look more closely at next time.
Last Post: Stepping Stone #3: Understanding Stockmarket History
Next Post: Stepping Stone #5: Know Your Limitations. KISS
1 comments:
This may be famous last words, but I'm genuinely not worried about people loading up on stocks at the moment provided they have a 10+ year investing horizon and a plan for rebalancing (as you sensibly mention) to get out.
I can't remember reading as many "markets do go down, even over the long-term" articles and posts as I've read in the past six months in the entire 15 years before them.
My contrarian signal indicator is smoking!
Not meaning to disparage your general post at all, nor the advice which is all sensible as ever. And indeed, it was this very blog that revealed the shocking government bonds versus equities long-term stats, so the point is well taken.
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