When investing, it is important to think about your time frame and your return expectations at the outset.
Time frame means for how long you expect to hold the investments. The longer your time frame, the less concerned you should be about short-term variance or volatility. Having a longer time frame allows you to invest in assets with less certainty but potentially higher returns.
When considering return expectations, certainty is rationally associated with lower returns, as in cash, bonds and term deposits, whereas uncertain investments are associated with higher returns, with investors needing a ‘premium’ to compensate for the uncertainty.
The challenge with equities, bonds and commodities is that they can vary dramatically over periods of time which most would consider ‘long term’.
Long-term returns: Equities vs bonds
UBS’s Global Investment Returns Yearbook documents the long-run return on stocks, bonds, bills, currencies, and other assets since 1900. Data over the 125-year period to 2024, shows that US equities have generated returns of 9.7% p.a. which has turned $1 into $107,409. UK equities have compounded at 9.1% p.a. turning £1 into £53,980. Even 0.6% makes a remarkable difference when compounded over 125 years!
Long bonds and bills (treasuries) saw UK returns exceed US, with 5% p.a. gains in UK bonds versus the US’s 4.6% p.a., and 4.6% in UK bills versus 3.4% in the US. However, inflation in the UK averaged 3.5% p.a. versus 2.9% in the US.
Real returns, taking inflation into account, saw US$1 in US equities grew to US$2,911 versus US$7.30 in bonds and US$1.80 in cash. US$1 in 1900 had the same purchasing power as US$37 today.
The effects of inflation
In terms of inflation, the study found that equities were not in fact a useful inflation hedge, but real returns were strongest by a factor of 2x in the lowest inflationary period and suffered heavy real losses in the highest inflationary period. The same applies to bonds, which is more obvious given bonds lose value when interest rates rise and vice-versa.
Interestingly, in regard to gold, while this has value as a hedge against inflation, with a 0.34 positive correlation to inflation since 1972, it can be volatile with a low long run return.
Setting return expectations
By examining the very long-term returns in equity and bond markets, and the volatility of those returns, the study aims to illustrate how difficult it is to set realistic expectations when investing in these assets. If your time horizon is less than 20 or even 40 years, expecting to achieve a certain return, particularly in equities, is unrealistic. They argue that even over long periods, investors can still experience unusual returns.
They say, “consider an investor at the start of 2000 who looked back on the 10.5% real (inflation adjusted) annualised return on global equities over the previous 20 years and regarded this as ‘long run’ history, and hence providing guidance for the future. But, over the next decade, our investor would have earned a negative real return on world stocks of −0.6% per annum.”
Golden ages by definition are exceptions and we need very long time series to support inferences about investment returns.
Since the GFC, we have had Covid and the bear market of 2022 when inflation soared and interest rates rose rapidly, inflicting losses on bonds and equities together. Nevertheless, it has been a strong period for global equities, averaging 12.9% p.a. since March 2009. Over the last 5 years, global markets have risen 13.9% p.a. led by the Nasdaq’s 15.0% p.a. which will perhaps go down as another golden era.
From history we can see the enormous volatility and risk that equity markets can deliver with long periods to recover.
The chart below shows the returns for every year between 1900 and 2024. The red boxes are the 21st century. There have been 43 years when shares lost money, and 11 years, or almost 10% of all years where they lost more than 20%. In this century, the market has lost money one in every three years, but one in four years has seen gains of more than 20%, including the last two years, 2023 and 2024.
Equities and Bonds – Do they meet expectations?
As we have written on many occasions, we don’t believe the equity market offers attractive risk reward over most investors’ time frame. However, we do believe that skilled investors can greatly reduce the risk of investing in equities and achieve higher returns or similar returns with less downside risk (see our article ‘Rethinking the 60/40 portfolio’). These investors will tend to own only a small subset of the market in a strategy they have mastered, but which protects capital from outsize losses yet still generates strong returns.
Bonds are also volatile and returns are low. The only period where bonds produced reasonable returns was post the 1970’s in which the oil shock sent inflation through the roof, with interest rates close behind. This 39 year period between 1982 and 2021 was the investment experience of my generation and led to the ‘balanced’ 60/40 bond equity mix becoming a truism. To this day it prevails as the ‘conservative’ approach to investing and is prevalent in almost every kiwisaver account. The more conservative the investors’ risk profile, the more bonds they will have. This destines these accounts to low returns with some equity risk attached.
The assumptions behind the 60/40 ‘asset allocation’ approach are grounded in an expected return from equities based on the very long term, and a notion that bonds will provide a reasonable return, despite proof from this study which shows bonds have only ever generated strong returns in one unique period of history.
If you’d like to discuss your portfolio, and how we can help you meet your return expectations through alternative investments, please get in touch with Mark or Sam.