High risk means high reward. You’ve got to speculate to accumulate. Such sayings are common-sense clichés. But they have been wrong for years.
I say so because of a simple fact. Investors have enjoyed great returns on diversified portfolios. For example, in the past 20 years a portfolio comprising 60 per cent UK equities and 40 per cent gilts would have made 5 per cent a year. That’s more than equities alone. And returns per unit of risk on this portfolio have been twice as good as those on equities alone. This of course is but one example – countless other diversified portfolios including gold and foreign currency have also done well.
From the point of view of orthodox theory, however, such great performance is just weird.
This theory predicts that balanced portfolios should underperform equities for two reasons.
The obvious one is simply that they are less volatile. Since 1990, a 60-40 equity-gilt portfolio has had a standard deviation of annual returns of only two-thirds that of equities. And while the worst annual loss on equities has been over 34 per cent, our balanced portfolio has not lost more than 20 per cent over a 12-month period.
Better still, because they contain lots of gilts balanced portfolios tend to do better in recessions. In the 2008-09 crisis and again during the worst of this year’s pandemic-induced fall, that 60-40 portfolio lost only half as much as equities alone. This is a great thing. It’s recessions that trouble us as these are the times when we are at most risk of losing our job or our business. We should therefore be happy to accept lower average returns on balanced portfolios in exchange for them holding up well when we most need financial security.
Balanced portfolios should therefore underperform equities – possibly by a lot depending on our risk aversion.
So why haven’t they? Obviously, it’s because bonds have delivered great returns as yields have fallen thanks to (depending on your preferences) an ageing population, savings glut, shortage of safe assets or dearth of productive investment opportunities caused in part by a declining profit rate.
In itself, though, this is no explanation. In theory, investors might have foreseen these trends and so priced them in, thereby giving us a consistently downward-sloping yield curve. But they didn’t. Instead, the gilt market has been consistently surprised by the strength of these forces. This is why gilt returns have been so good.
To explain the good returns on gilts and hence on balanced portfolios, we need an explanation of why investors have been surprised. One possibility here is the recency bias: investors attach too much weight to recent and current events and so fail to foresee that these will change.
It’s not just good returns on bonds that have given us great returns to diversification, though. In the past 20 years equity and gilt returns have been negatively correlated, causing balanced portfolios to be quite stable.
This might be a product of secular stagnation. A big danger for portfolios of gilts and equities is that short-term interest rates might rise, causing losses on both assets as investors switch into cash. This was a common event in the 1970s and 1980s, but except for the 'taper tantrum' of 2013 we haven’t seen it recently. This is because growth has consistently undershot expectations, causing short-term rates to trend downwards.
All this poses a danger for balanced portfolios. One threat is that the consistent downtrend in bond yields might stop or go into reverse. Another is that rising interest rates could trigger losses on both equities and gilts. Sure, this is not an immediate threat, but it could happen sometime.
So, why then might diversification continue to pay off?
For it to do so, we need good returns on bonds for reasons that don’t hurt shares. One possibility here has been described by Alan Taylor and Joseph Kopecky. They argue that ageing populations could drive down bond yields while keeping equity returns high. But this poses the question: why aren’t bond markets adequately pricing in the prospect of falling yields?
A more radical reason has been suggested by Eric Falkenstein at Pine River Capital Management. He says there is in fact no general trade-off between risk and returns, so safe assets such as bonds need not underperform equities.
For all its radicalism, there’s evidence for this. Defensive stocks have for years outperformed riskier speculative ones. And until this year there was a tendency for higher implied volatility on equities to lead to lower returns.
We do, then, have some reasons to expect diversification to continue to pay off well. But let’s be clear. The world in which this happens is one in which basic common sense is wrong. It is a world in which there is no trade-off between risk and return and in which investors, contrary to the rational markets hypothesis, are consistently surprised.
Personally, I wouldn’t rule out such possibilities entirely. But nor would I bet everything on conventional economics and common sense being so continuously wrong. For this reason, it's wise to hold cash despite its nugatory return, because it protects us from the risk of other assets falling at the same time.
