- Conventional economics suggests investors should hold only a low proportion of their wealth in equities.
- Investors actually heed this advice, because our wealth includes capitalised pension income, which is huge.
Many investors should invest a lot in equities – but not for the reasons you might think.
To see why, let’s start in 1969. Back then Robert Merton, who was later to win a Nobel prize, proposed a simple equation to tell us how to divide our wealth between equities and safe assets. The proportion you put into equities, he showed, should be equal to the expected annual outperformance of equities over cash, divided by a measure of risk aversion multiplied by the square of the volatility of equities.
This equation does not give us a simple definitive answer. Instead, it does what maths should do: it organises our thinking.
As a first pass, let’s put some numbers on this. Conventional economic theory – as described in Rajnish Mehra and Ed Prescott’s classic 1985 paper – says we should expect shares to outperform cash by no more than around two percentage points a year. A well-diversified equity portfolio should have an annual standard deviation of around 15 percentage points, the square of which is 0.0225. And while our attitude to risk varies from person to person, time to time and context to context, a reasonable estimate for an average person is around three. Plugging these numbers into Merton’s equation gives us 0.02 divided by (0.0225 x 3), or 0.296.
Which tells us that a typical investor should hold less than a third of their wealth in equities.
This seems low, but there’s an intuitive justification for it. An equity premium of just two percentage points a year implies that even over a 20-year period there’s around a one-in-five chance of under-performing cash. That’s a waste of a long investment career. For cautious folk, this is a sufficiently grim prospect to justify a lowish equity weighting.
Most of you, I suspect, have much more in shares than this. Can this be justified?
Obviously, yes if you are less cautious than I’ve assumed. But there are more interesting reasons.
One is that equities could outperform cash by more than two percentage points.
Certainly, they have done so in the past. Since 1900 UK equities have delivered a real annual return of 5.5 per cent while Bank rate has averaged 1.2 per cent in real terms. That’s a premium of 4.3 percentage points.
This, however, might be misleading. For much of the 20th century shares were lowly priced to reflect the risk of wars, revolutions, high inflation and severe depressions. As these risks didn’t materialise, equities enjoyed a relief rally, doing especially well from the mid-1970s to late 1990s.
That, however, might now be a thing of the past. My chart shows why, showing the annualised return you’d have made on UK equities relative to gilts for each month since 1985. It shows that you would only have made a decent equity premium if you had bought at the right times, such as immediately after the tech burst of 2000-03 or the financial crisis of 2007-09. Generally, the equity premium as been as low as the Mehra-Prescott theory predicts.
Luckily, though, there is a reason to justify expecting a high equity premium in future, pointed out by the University of Warwick's Roger Farmer. It is simply that younger people cannot buy as many equities as they should simply because they don’t have the cash, and (unlike in the housing market) cannot borrow to invest. This causes demand for equities and therefore their prices to be lower than theory suggests they should – which means higher returns for those who are able to buy.
An equity premium of around four percentage points, combined with slightly less risk aversion than I’ve assumed, can justify putting 90 per cent of our wealth into shares.
But only for some people. Economists at Monash University have pointed out that if you have a mortgage or other debt what matters isn’t prospective returns on equities relative to cash, but their returns relative to the interest on your borrowings. This gap is smaller than that with cash. Which means that for many – especially the risk-averse – it’s better to pay off debts.
There is, however, a stronger reason for many of us to hold lots of equities. It’s that they are not as risky as their volatility suggests, because many of us are diversifying such risk. If you have a safe job, you can react to equity losses by saving more or working longer. Sure, both are inconvenient, but they allow us to mitigate those losses, enabling us to take on more equity risk than the Merton equation implies.
But this is only true for some. If you’re in a riskier job, or running a small business, equities actually add to your risk – which means you should hold less than the equation predicts.
Many of you, however, have another protection against equity risk. The Merton equation applies to your wealth as a whole. And this wealth includes the capitalised value of your pension income. Which is a big sum. At just over £7,100 a year the basic state pension seems paltry. But at current annuity rates it is worth over £170,000. That’s part of your wealth. Which means that if you have, say, £250,000 in other financial wealth my initial calculation suggests it’s reasonable to put half of that into shares. If you have a final salary pension on top of this, it too justifies having a big proportion of your other wealth in equities.
Large equity weightings, then, are perhaps quite reasonable – even if you are a cautious investor who anticipates only moderate equity returns. One under-appreciated benefit of the welfare state is that it supports stock market investment.
