Join our community of smart investors

Is the era of easy money over?

Last year I pointed out that very simple portfolios held up well during the slump in share prices caused by the pandemic. But how have they done since then? The answer is: just fine.

Let’s consider the portfolio I proposed in early 2020 – one comprising 50 per cent in a fund that tracks MSCI’s world index, 20 per cent in gilts and 10 per cent each in UK cash, gold and US dollars. In the last 12 months, it has risen 11.7 per cent as big gains on equities have outweighed small losses on gilts and gold.

In fact, though, this isn’t terribly impressive. It is lower than the returns on dozens of funds in Trustnet’s database of mixed investment unit trusts – largely because many of these had bigger equity weightings.

What’s more impressive is the longer-term performance of this portfolio. In the last 10 years it would have more than doubled your money. Only 32 of the 203 funds in the mixed investment 40-85 per cent equity category have done better.

And these returns have come at relatively little risk. In monthly data, this portfolio has seen only one annual loss (before inflation) since 2009 – and that of only 0.7 per cent in the 12 months to March 2018. This is largely because gilts and equities have been negatively correlated for much of this time, but also because sterling has sometimes fallen when equities have fallen, giving us profits on US dollars and gold to offset equity losses.

This is all the more remarkable when you consider what this portfolio does not do. It doesn’t use any selling rule such as selling when prices are below their 10-month average or 'sell in May' even though both would have improved returns. It doesn’t use any optimisation: the portfolio weights were chosen as no more than reasonable round numbers. It doesn’t use any lead indicators to tell us when to change exposure to equities even though several of these, such as valuations, the yield curve or money-price ratios, have predictive power. And it uses no judgment at all about future asset returns or macroeconomic conditions.

Despite renouncing almost all the conventional asset allocation tools, this portfolio has done well.

Which tells us that investing is an easy job. You don’t need effort, thought, or ability. Just split your money across a few assets and get on with the rest of your life.

This seems counter-intuitive. We live in a complex and unpredictable world, so you might imagine that we need clever complex strategies to cope with this. But we don’t. Gerd Gigerenzer at the Max Planck Institute has show that rough rules of thumb often work well. The psychologists Paul Meehl and Robyn Dawes have shown that rough statistical methods can perform as well as expert judgment. And the London Business School’s Victor DeMiguel and colleagues have shown that naïve diversification works well. The performance of my simple portfolio fits into this tradition.

Sadly, however, things are not so simple.

The precise numbers for my portfolio’s returns are based upon rebalancing it every month to maintain those 50-20-10-10-10 weightings. For retail investors this is impractical. But this doesn’t much matter. Less regular rebalancing would result in similar performance – and sometimes better when markets are momentum-driven. And there’s nothing special anyway about these weights. Similar ones would also have done well. In fact, a portfolio with 40 per cent in equities and the rest split evenly between gold, gilts, UK and US cash would have had a slightly higher Sharpe ratio since 1990.

The fact is that rough diversification does well. The precise numbers on particular portfolios are merely illustrations of this important general fact.

Sadly, however, just because simple diversification has worked in the past does not mean it will continue to work in the future.

The last three decades have been very kind to asset managers. Not only have we had long bull markets in global equities and bonds, but we’ve also had low short-term correlations between the two. Any fool could deliver decent risk-adjusted returns in these conditions.

But this might change, and not just because the bull markets in equities and bonds might be over.

One danger is that if or when UK and US interest rates rise we could see equities and gilts sell off together, and gold as well because it is sensitive to changes in bond yields.

There’s another danger. The tendency for sterling to fall when stock markets do badly might not continue. If we see a deflation in US equity valuations we could also see the dollar fall as well, as part of a decline in demand for US assets generally. In such an event, sterling-based investors would see losses not just on global equities but also on dollars and perhaps gold, too.

It’s quite simple to protect ourselves from these risks: we can hold more cash and fewer US equities.

But that’s not the point. The point is that is has for decades been child’s play to run a balanced portfolio. But it might not remain so – in which case fund managers will finally have to earn their money.