If you follow the crowd, you will fall off the cliff………

Over the last few days I have come to the conclusion that the potential for strong equity returns over other perceived safe investments has never been greater, and in this piece I want to explore this further.

A lot of my thoughts centre around perception and in particular the perception of risk.

We all know that cash and bonds are seen at the lowest end of risk and equities at the highest. Regulatory bodies, despite what is plainly obvious to all, continue to promote cash at the lowest end. Of course this is because risk is defined as the permanent loss of capital. In theory investing in cash means your capital is never really at risk unless of course you invest in Iceland, Cyprus and others! Whereas with equities there is always a risk that capital could be lost and this is one of the greatest fears for investors.

Crunching the numbers

From 1950 to date globalised annualised returns on equities was 6.8%, from 1980 this was 6.4% and over the last 13 years just 0.1%.

Bonds over the same period were 3.7%, 6.4% and 6.1%. In fact from 1980 to date bonds just outperformed equities and this was no doubt helped by the performance over the last 13 years.

Cash from 1980 has returned 2.7% p.a.

But by 2012 bond yields in many developed economies had hit all-time lows and nominal interest rates were turning negative so effectively investors were paying for the privilege of safety.

Going forward real bond yields remain low, 20 year real yields in the US are Zero and -0.1% in the UK. Real cash hasn’t fared any better, the real return on treasury returns in the US was -1.7% and -2.7% in the UK.

Recent research has predicted real returns on cash over the next five years will be zero and government bonds will be

-1.5%.

Clearly these are no longer low risk ‘safe’ investments and evidence indicates in real returns investors will lose money.

The great reversal

If cash and bonds are no longer safe then how can you achieve growth and income? Obviously there are other asset classes like property and that is a whole separate subject but high property prices, and low yields may not make this accessible to the average investor.

So the place to go appears to lead you to equities, but clearly investors will want to be rewarded for taking that higher degree of risk.

On the same assumptions used for bonds and cash it is projected that the real return of equities after inflation will be in the region of 3 to 3.5% over the next 20 to 30 years. This possibly isn’t what people want but it is still considerably higher than cash and bonds. It is projected that real interest rates will not return to a positive position for 6 to 8 years and even then it will be projected to be around 0.9%.

Clearly investors face a challenge; low interest rates and bond yields mean that the idea of ‘safe’ investments no longer exists and therefore equities have to be considered as an alternative, but long term returns could be considerably lower than in the past.

What can be done?

Where investors are considering moving from cash to equities they need to either accept this lower level of returns, or be prepared to take a higher degree of risk to achieve greater returns. It is important to stress that risk for us is about volatility. Investors don’t need to invest in high risk products which potentially lose capital but they can invest where volatility is low, the degree of volatility depends on the client’s ‘attitude to risk’.

The research assumes all markets behave the same, so we assume all emerging markets are the same - whereas the likes of Mexico, Brazil, South Korea etc are very different to the likes of India and Indonesia which have suffered from the withdrawal of foreign currencies. Therefore to win in this new world investors need to be prepared to diversify and consider actively managed investments.

Not all markets are the same

It can be argued over the last 3 years investors would have got stronger returns from a fund which tracks the S&P 500 compared to an actively managed fund. I would argue to achieve 3 to 3.5% a year, a fund which tracks the index should deliver this but there are considerable dangers.

Funds which track an index consider that all components of that market are the same, and perhaps in certain periods this is the case but long term it is not. Over the next 10 to 20 years we have indicated that frontier markets offer the potential to be the new emerging markets, and equally this will feed into the potential for emerging markets as economies start to become more mature. What is important is that not all the economies within these areas are the same.

Choosing an active manager who can diversify the portfolio and identify the economies they feel will succeed will be key to success. A fund that tracks an index will not be able to do this.

Equally some developed economies over the next ten to twenty years offer incredible opportunities which of course feed into frontier and emerging markets.  The US is predicted to be the largest oil producer by 2017; this is a game changer. Now investing in an S&P500 fund which just tracks the index will not necessarily give investors the opportunities to invest in companies that will benefit from the growth in the US. The type of companies which are likely to benefit are small to mid-cap companies, that is not to say large cap won’t do well but the real drivers are like to be further down the market capital share because they are more closely involved.

Equally Japan is facing a final roll of the dice, we have heard it before but this time it has a mandate for reform and this cannot be ignored. The Prime Minister controls both the upper and lower houses of parliament, the new head of the central bank is in favour of the new policies and there are much younger leaders behind companies who have the ear of the Prime Minister.

We should also not discount the UK which has been coming out of the recession over the last 12 months, there is still some work to be done but investing in the right companies could provide significant returns over the long term.

In summary not all markets are the same and different markets offer different opportunities.

Should we just ignore bonds and cash?

Bonds as part of a diversified portfolio remain an important part but these markets are not the same either. Many managers will claim that emerging market debt is not the place to be, these managers tend to be managers who manage large portfolios of UK debt and would be mad to say anything else. Could you imagine if they said you should no longer invest in their funds, it would be falling on your sword!

As I do not manage UK debt I will say it, the evidence from Credit Suisse and Barclays would indicate just that. However as is the message of this piece, not all bond investing is the same. We remain of the belief that emerging market debt will outperform the developed market. There has been a strong correction and this was mainly due to QE and the sell-off in US treasuries, Chinese growth worries and weakness in commodity prices.

But emerging market debt is different in that the economies are growing faster than the developed world, they have lower debt levels, their fiscal positions are getting stronger and their current accounts are improving.

So developed market bond investing may offer little opportunity and actually offer the potential for negative returns however some emerging market economies offer the reverse. There is of course more volatility than UK bonds but it is about the same as global bonds.

It is not a homogenous group and different economies are doing better than others so again the key is good active management rather than a fund which just tracks the index; so careful bond choice should not be ignored.

Where now for cash? We have seen accounts offering higher rates if investors are prepared to lock their money away for five to seven years with no access to the capital. If an investor is prepared to do this for this period of time then I would argue that they would be better to place it in a diversified portfolio of investments where they would always have access to the money. Again it depends on your ‘attitude to risk’.

Where next

Of course investors will always want to hold cash because of the perceived safe nature of these investments but in time investors will start to find that savings are dwindling and by then the damage may be irreparable.

The argument for equities is very strong but it will take investors time to see this, with the drive to lower costs the danger is that investors invest in the wrong way and this will be damaging for the long term.

The key is diversification, using active management and identifying where the growth areas will be going forward. It doesn’t mean a portfolio is stacked high with frontier markets or US but it means it favours areas where the greatest potential growth is and then managers who can exploit that growth. Bonds can be part of that but again it may mean breaking with convention to generate returns.

In summary it’s time for regulatory bodies, journalists and others to change their mind-set and accept that investing has changed. For investors, diversification and active managers are key to achieve long term success but there has to be an acceptance of greater volatility to deliver greater returns. 

We feel there is a choice for investors, they either follow the crowd and they will fall off the cliff or they can break with the crowd and go against the grain and this will deliver long term success.

Source: NAPF Investment Insight: Equities vs Bonds, Credit Suisse Global Investment Returns Yearbook 2013 and Barclays Equity Gilt Study 2013

Please note: These are the personal views of demystifyadvice and do not constitute advice. Any reference to a share is not a recommendation to sell or buy that share / fund. You should carry out your own research before making any decision. You should also note that past performance is no guide to future performance and investments can fall as well as rise.