Everybody knows that 2018 was a bad year for equities. It was not, however, so terrible for investors because many balanced portfolios actually held up well.
Of course, there are countless such portfolios. For the sake of concreteness let’s consider just one – one that has 60 per cent in MSCI’s world index, 20 per cent in cash, and 10 per cent each in gilts and gold, all measured in sterling terms.
Such a portfolio lost a mere 0.9 per cent before inflation last year. A big reason for this is that sterling fell by almost 6 per cent against the dollar, which meant that losses on global equities in sterling terms were small – MSCI’s world index, including dividends, lost only 3 per cent in sterling terms. The pound's fall also meant that gold made a small profit. With cash and gilts also giving a small positive return this meant that a balanced portfolio lost very little. Portfolios with a lower weight in equities would of course have done even better.
Modest as it was, this loss was unusual. It was the first annual loss for such a portfolio since June 2009. Of course, equities have lost during this time, but those losses were offset by gains on gilts and gold.
All this shows that very simple diversification works. To quantify this, this balanced portfolio has given an average annual return of 7.9 per cent since 1986, 1.2 percentage points less than the All-Share index. But its annualised volatility has been much lower, at 10.3 against 15.8 percentage points. That implies the Sharpe ratio (returns divided by volatility) has been 30 per cent higher than that on the All-Share index. And the worst annual loss on this portfolio has been 19.2 per cent against 34.4 per cent on UK equities.
Spreading our wealth across a few simple asset classes can therefore protect us from lots of risk. We don’t need fancy or expensive strategies.
Or at least, this has been true in recent years. It poses the question: under what circumstances might simple diversification fail? I suspect there are three possibilities.
One would be if there is a tightening of monetary policy, especially around the world. If this triggers a flight to cash and away from bonds and equities, balanced portfolios would suffer. The worst annual loss on this portfolio came in 1990, when UK rates rose sharply.
A second possibility would be if sterling rose, which would (other things equal) cause losses on overseas assets. This portfolio held up well in 2008-09 in part because sterling fell then. It did worse in 1900 and 2000-01 when the pound rose.
A third danger comes from the fact that there’s a limit to how far gilt yields can fall – the fact that there’s a lower bound to short-term interest rates puts a floor under gilt yields. Yes, experience in Germany (among other places) shows that even longer-dated yields can turn negative. But not very much so. This means that if or when we get a serious recession that requires the Bank of England to restart quantitative easing gilts would not do extremely well. Which means they probably wouldn’t offset the big losses we’d see on shares in the event of a major global economic downturn.
It would be futile to quantify the probability of these scenarios. Rising interest rates are only a big danger for equities if central bankers misjudge the health of the economy and raise rates too much: otherwise, shares actually benefit from the same economic growth that causes rates to rise. The fate of the pound depends in large part on what happens (or doesn’t) with Brexit. And recessions are largely unpredictable, except perhaps by looking at whether the US yield curve is inverted or not.
We can, though, say two things. One is that the chances of significant losses on balanced portfolios are not negligible, even though it’s a long time since we’ve seen them. The other is that it is in fact quite easy to protect against them simply by holding more cash. It is easy to avoid big losses, if this is all you want to do.
