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The case for safe assets

Safe assets offer negative real returns. But investors should stick with them
October 8, 2020

Investors face a sharp trade-off between risk and return – but this doesn’t justify switching into equities.

Our problem is that expected returns on safe assets are low, and negative after inflation. Futures markets are pricing in no rise in interest rates until 2025. That suggests we face years of real interest rates being around minus 2 per cent – which not coincidentally is also the real yield on index-linked gilts.

We can’t guarantee better returns on foreign currencies. This isn’t just because most of these also offer nugatory interest rates. It’s also because we’ve no reason to expect them to appreciate against sterling. There are two not-so-bad theories of exchange rates. One is that they follow a random walk, which implies we should expect no systematic rise in foreign currency. The other is that changes in nominal rates can be predicted by the level of the real exchange rate. As sterling is cheap by the latter measure, this points to most major currencies falling.

Nor is gold a better bet. It moves inversely with bond yields. So unless the latter fall, its price won’t rise.

Of course, these assets will do well if investors’ appetite for risk falls. But this is only one possibility. We should instead assume that, on average, likely returns on such assets will be negative. This of course is a sharp contrast to recent years, when rising prices of gold, bonds and foreign currency have meant that savers have been well rewarded for taking risk. But we cannot invest as if the future will resemble the past.

By contrast, prospects for equities might be good. Granted, the trailing dividend yield on the All-Share index of 4.5 per cent is flattered by the fact that dividends will be cut in coming months. But it’s reasonable to assume (with a large margin of error) that real annual returns will be around 5 per cent, comprising 1.5 per cent of capital gain – in line with likely average economics growth – and 3.5 percentage points of yield pick-up.

Plausible assumptions, then, suggest a real loss of 2 per cent per year on safe assets and a real gain of 5 per cent on risky ones. Hence the sharp trade-off between risk and return.

This does not, however, justify us abandoning safe assets. To see why, we need a framework proposed in 1969 by Robert Merton, who would later win a Nobel prize. He showed that our asset allocation between safe and risky assets should be determined by a simple equation. It should be equal to the risk premium on risky assets, divided by the product of the variance of annual returns on the risky asset and a measure of our risk aversion.

Now, our best-case assumption is for a risk premium of seven percentage points, or 0.07. History suggests the variance of annual equity returns is 0.04: this is the square of a standard deviation of 20 percentage points. The degree of risk aversion varies from person to person, but a reasonable average would be three, where one represents indifference to risk and higher numbers greater risk aversion.

Plugging these number’s into Merton’s equation tells us that we should have 58 per cent of our wealth in equities. That is, 0.07/(0.04 x 3).

In other words, an average investor should have around two-fifths of her assets in safe assets, despite their low prospective returns.

You might find this surprising. But the logic is simple. Even high expected returns on equities are consistent with the possibility of large losses over shortish periods. On these numbers, there’s around a one-in-four chance of shares losing 10 per cent or more in a 12-month period. We need safe assets to protect us from this.

Our equation also tells us that our asset allocation depends upon the difference between prospective returns, not their absolute levels. So a risk premium of seven percentage points gives us the same asset allocation, whether safe assets return minus 2 per cent or plus 5 per cent.

Why, then, do so many investors seem to think differently, and believe that negative rates are a reason to take more risk?

Partly, I suspect, it is for the same reason that people who have lost money at the race course or casino place bigger riskier bets on the last race or as the night progresses. As Daniel Kahneman and Amos Tversky wrote in their classic paper, Prospect Theory: “A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.” The prospect of losses on cash drives us to take more risk – to reach for yield.

In doing this, investors forget something important – that likely returns on cash and bonds are low because central banks and investors believe the global economy is in fragile health. This is an environment in which losses on equities are more likely than usual. And they could be much worse than the 2 per cent real loss that safe assets offer.

Reaching for yield is therefore unwise.

But it is what central banks want us to do. One channel through which low interest rates stimulate the economy is by tempting investors to buy equities and corporate bonds, which raises their prices and so cuts companies’ cost of capital, thereby encouraging them to invest and hire.

What we have here, therefore, is something that is the essence of social science – a conflict between individual self-interest and the collective good. The former tells us to be wary of equities; the latter tells us to pile in. Whether you should invest for the collective good is, however, far from obvious.